What is a Mortgage?

A mortgage is a method of using property (real or personal) as security for the payment of a debt.

The term mortgage (from Law French, lit. death vow) refers to the legal device used in securing the property, but it is also commonly used to refer to the debt secured by the mortgage, the mortgage loan.

In most jurisdictions mortgages are strongly associated with loans secured on real estate rather than other property (such as ships) and in some cases only land may be mortgaged. Arranging a mortgage is seen as the standard method by which individuals and businesses can purchase residential and commercial real estate without the need to pay the full value immediately. In many countries it is normal for home purchases to be funded by a mortgage.

In countries where the demand for home ownership is highest, strong domestic markets have developed, notably in Spain, the United Kingdom and the United States.

Definition of a Mortgage:

"mort-gage"

1. A temporary, conditional pledge of property to a creditor as security for performance of an obligation or repayment of a debt.
2. A contract or deed specifying the terms of a mortgage.
3. The claim of a mortgagee upon mortgaged property.
4. A conveyance of an interest in property as security for the repayment of money borrowed

Word History of Mortgage

The great jurist Sir Edward Coke, who lived from 1552 to 1634, has explained why the term mortgage comes from the Old French words mort, "dead," and gage, "pledge." It seemed to him that it had to do with the doubtfulness of whether or not the mortgagor will pay the debt. If the mortgagor does not, then the land pledged to the mortgagee as security for the debt.

Participants of Mortgage and Terminology
In general terms the main participants in a mortgage are:

Creditor: The creditor has legal rights to the debt secured by the mortgage and often makes a loan to the debtor of the purchase money for the property. Typically, creditors are banks, insurers or other financial institutions that make loans available for the purpose of real estate purchase. A creditor is sometimes referred to as the mortgagee or lender.

Debtor: The debtor[s] must meet the requirements of the mortgage conditions (and often the loan conditions) imposed by the creditor in order to avoid the creditor enacting provisions of the mortgage to recover the debt. Typically the debtors will be the individual home-owners, landlords or businesses who are purchasing their property by way of a loan. A debtor is sometimes referred to as the mortgagor, borrower, or obligor.

Legal Aspects

There are essentially two types of legal mortgage.
Mortgage by demise: In a mortgage by demise, the creditor becomes the owner of the mortgaged property until the loan is repaid in full (known as "redemption"). This kind of mortgage takes the form of a conveyance of the property to the creditor, with a condition that the property will be returned on redemption.
Mortgage by legal charge: In a mortgage by legal charge, the debtor remains the legal owner of the property, but the creditor gains sufficient rights over it to enable them to enforce their security, such as a right to take possession of the property or sell it.

What is a Mortgage Loan?

In simple terms, a mortgage loan is a loan made to an individual or group of individuals secured by a piece of property. The property itself is held as collateral or security ("the mortgage") for the repayment of the loan.

A mortgage loan can either be a loan of money for a purchase, such as a loan obtained when a home is bought, or a loan of money for a non-purchase, such as a refinance of an existing mortgage loan. The remainder of this discussion will be about loans of money for a purchase. Refinancing will be discussed later under Refinance or Refinance Property.

When a borrower obtains a mortgage loan, he or she borrows the amount of money required to pay for the property. This is the principal, the amount of money actually being borrowed. Money is loaned for a mortgage at a particular interest rate-interest is what the lender charges you to use the money being borrowed. Payment of the interest is spread out over the life of the loan such that at the end of the loan term, the full amount of principal and interest has been paid.

Other charges may be spread out over the life of the mortgage or over specific portions of it, such as taxes and insurance for the property or private mortgage insurance (PMI) for loans of more than 80% of the property's value. Taxes and insurance may be included in mortgage payments as a service to the borrower, who may wish to make monthly payments for those expenses rather than semi-annual or annual payments, or as a safeguard for a lender to make sure that taxes and insurance payments are current.

Private mortgage insurance (PMI) is charged by most lenders for loans of more than 80% of the property's value. This is the insurance for the lender in case the borrower defaults on the mortgage. PMI can be canceled when the mortgage balance dips below the 80% value mark.

Mortgages come in a variety of flavors. Loan terms can be anywhere from 10 to 30 years, though the most common is either a 15- or 30-year loan. The most typical loan types are fixed rate, (FRM) adjustable rate (ARM), or convertible rate (CRM).

1. A fixed rate mortgage (FRM) is a loan with an interest rate that remains the same for the entire term of the loan. Fixed rate loans are recommended if you are planning to keep your home for many years and you expect overall interest rates to increase or remain stable.
2. An adjustable rate mortgage (ARM) is a loan with an interest rate that adjusts periodically to reflect changes in a specified financial index. These loans generally have the lowest initial rate and payment. They are recommended if you plan to keep the loan for a short time (less than three years), expect your income to increase substantially, or expect rates to decrease. You may qualify for a larger loan amount with an ARM than you would with a fixed rate mortgage
3. A convertible rate mortgage (CRM) is a combination of a fixed rate and an adjustable rate loan. It usually has a fixed rate for the first few years and then converts to an adjustable rate for the remainder of the loan term. The starting rate is usually higher than an adjustable rate loan but lower than a fixed rate loan.

A first mortgage or "first" is the primary mortgage on a property that has priority over any and all other mortgages. A second mortgage or "second" is the secondary mortgage on a property with priority over any and all other mortgages, except for the first mortgage. Typically a property will have only a first and possibly a second mortgage placed on it, but there can be as many mortgages on a piece of property as a lender will give.

Mortgage loan & Participants:

Mortgage Loan is the generic term for a loan secured by a mortgage on real property; the "mortgage" refers to the legal security, but the terms are often used interchangeably to refer to the mortgage loan. Mortgage loans generally refer to a loan secured by residential property, often for the purpose of acquiring the residence. Mortgage loans may be lower priced than other forms of borrowing because the value of the property reduces risk for the lender.

Mortgage lending is the primary mechanism used in many countries to finance private ownership of residential property:

• Property: the physical residence being financed. The exact form of ownership will vary from country to country, and may restrict the types of lending that are possible.
• Mortgage: the security created on the property by the lender, which will usually include certain restrictions on the use or disposal of the property (such as paying any outstanding debt before selling the property).
• Borrower: the person borrowing who either has or is creating an ownership interest in the property.
• Lender: any lender, but usually a bank or other financial institution.
• Principal: the original size of the loan, which may or may not include certain other costs; as any principal is repaid, the principal will go down in size.
• Interest: a financial charge for use of the lender's money.
• Foreclosure or repossession: the possibility that the lender has to foreclose, repossess or seize the property under certain circumstances is essential to a mortgage loan; without this aspect, the loan is arguably no different from any other type of loan.

Mortgage loan Basics:

Mortgage loans are generally structured as long-term loans, the periodic payments for which are similar to an annuity and calculated according to the time value of money formulae. The most basic arrangement would require a fixed monthly payment over a period of ten to thirty years, depending on local conditions. Over this period the principal component of the loan (the original loan) would be slowly paid down through amortization. In practice, many variants are possible and common worldwide and within each country.

Lenders provide funds against property to earn interest income, and generally borrow these funds themselves (for example, by taking deposits or issuing bonds). The price at which the lenders borrow money therefore affects the cost of borrowing. Lenders may also, in many countries, sell the mortgage loan to other parties who are interested in receiving the stream of cash payments from the borrower, often in the form of a security (by means of a securitization). In the United States, the largest firms securitizing loans are Fannie Mae and Freddie Mac, which are government sponsored enterprises.

Mortgage lending will also take into account the (perceived) riskiness of the mortgage loan, that is, the likelihood that the funds will be repaid (usually considered a function of the creditworthiness of the borrower); that if they are not repaid, the lender will be able to foreclose and recoup some or all of its original capital; and the financial, interest rate risk and time delays that may be involved in certain circumstances.
More recently, mortgage loan brokers have expanded their businesses to include a web presence. There is now even a market for standard mortgage web templates which are used by brokers who want to quickly develop an online component to their business. An example for such accompany would be www.iMortgagesites.com.

The deed of trust

The deed of trust is a deed by the borrower to a trustee for the purposes of securing a debt. In most states, it also merely creates a lien on the title and not a title transfer, regardless of its terms. It differs from a mortgage in that, in many states, it can be foreclosed by a non-judicial sale held by the trustee. It is also possible to foreclose them through a judicial proceeding. Most "mortgages" in California are actually deeds of trust. The effective difference is that the foreclosure process can be much faster for a deed of trust than for a mortgage, on the order of 3 months rather than a year. Because the foreclosure does not require actions by the court the transaction costs can be quite a bit less.

Mortgage lien priority

Except in those few states in the United States that adhere to the title theory of mortgages, either a mortgage or a deed of trust will create a mortgage lien upon the title to the real property being mortgaged. The lien is said to "attach" to the title when the mortgage is signed by the mortgagor and delivered to the mortgagee and the mortgagor receives the funds whose repayment the mortgage secures. Subject to the requirements of the recording laws of the state in which the land is located, this attachment establishes the priority of the mortgage lien with respect to other liens on the property's title. Liens that have attached to the title before the mortgage lien are said to be senior to, or prior to, the mortgage lien. Those attaching afterward are said to be junior or subordinate. The purpose of this priority is to establish the order in which lien holders are entitled to foreclose their liens in an attempt to recover their debts. If there are multiple mortgage liens on the title to a property and the loan secured by a first mortgage is paid off, the second mortgage lien will move up in priority and become the new first mortgage lien on the title. Documenting this new priority arrangement will require the release of the mortgage securing the paid off loan.

What is Mortgage Process?

In the U.S., the process by which a mortgage is secured by a borrower is called origination. This involves the borrower submitting an application and documentation related to his/her financial history and/or credit history to the underwriter. Many banks now offer "no-doc" or "low-doc" loans in which the borrower is required to submit only minimal financial information. These loans carry a slightly higher interest rate (perhaps 0.25% to 0.50% higher) and are available only to borrowers with excellent credit.

Sometimes, a third party is involved, such as a mortgage broker. This entity takes the borrower's information and reviews a number of lenders, selecting the ones that will best meet the needs of the consumer.

Loans are often sold on the open market to larger investors by the originating mortgage company or the Lender / Bank. Many

of the guidelines that they follow are suited to satisfy investors. Some companies, called correspondent lenders, sell all or most of their closed loans to these investors, accepting some risks for issuing them. They often offer niche loans at higher prices that the investor does not wish to originate.

If the underwriter is not satisfied with the documentation provided by the borrower, additional documentation and conditions may be imposed, called stipulations. The meeting of such conditions can be a daunting experience for the consumer, but it is crucial for the lending institution to ensure the information being submitted is accurate and meets specific guidelines. This is done to give the lender a reasonable guarantee that the borrower can and will repay the loan. If a third party is involved in the loan, it will help the borrower to clear such conditions.

The following documents are typically required for traditional underwriter review. Over the past several years, use of "automated underwriting" statistical models has reduced the amount of documentation required from many borrowers. Such automated underwriting engines include Freddie Mac's "Loan Prospector" and Fannie Mae's "Desktop Underwriter". For borrowers who have excellent credit and very acceptable debt positions, there may be virtually no documentation of income or assets required at all. Many of these documents are also not required for no-doc and low-doc loans.

• Credit Report
• 1003 - Uniform Residential Loan Application
• 1004 - Uniform Residential Appraisal Report
• 1005 - Verification Of Employment (VOE)
• 1006 - Verification Of Deposit (VOD)
• 1007 - Single Family Comparable Rent Schedule
• 1008 - Transmittal Summary
• Copy of deed of current home
• Federal income tax records for last two years
• Verification of Mortgage (VOM) or Verification of Payment (VOP)
• Borrower's Authorization
• Purchase Sales Agreement
• 1084A and 1084B (Self-Employed Income Analysis) and 1088 (Comparative Income Analysis) - used if borrower is self-employed
  

Mortgage Loan Types

There are many types of mortgages used worldwide, but several factors broadly define the characteristics of the mortgage. All of these may be subject to local regulation and legal requirements.

• Interest: interest may be fixed for the life of the loan or variable, and change at certain pre-defined periods; the interest rate can also, of course, be higher or lower.
• Term: mortgage loans generally have a maximum term, that is, the number of years after which an amortizing loan will be repaid. Some mortgage loans may have no amortization, or require full repayment of any remaining balance at a certain date, or even negative amortization.
• Payment amount and frequency: the amount paid per period and the frequency of payments;

in some cases, the amount paid per period may change or the borrower may have the option to increase or decrease the amount paid.
• Prepayment: some types of mortgages may limit or restrict prepayment of all or a portion of the loan, or require payment of a penalty to the lender for prepayment.

The two basic types of amortized loans are the fixed rate mortgage (FRM) and adjustable rate mortgage (ARM) (also known as a floating rate or variable rate mortgage). In United States, fixed rate mortgages are typically considered "standard". Combinations of fixed and floating rate are also common, whereby a mortgage loan will have a fixed rate for some period, and vary after the end of that period.

In a fixed rate mortgage, the interest rate, and hence periodic payment, remains fixed for the life (or term) of the loan. In the U.S., the term is usually up to 30 years (15 and 30 being the most common and now 40 year period is available as well), although longer terms may be offered in certain circumstances. For a fixed rate mortgage, payments for principal and interest should not change over the life of the loan, although ancillary costs (such as property taxes and insurance) can and do change.

In an adjustable rate mortgage, the interest rate is generally fixed for a period of time, after which it will periodically (for example, annually or monthly) adjust up or down to some market index. Common indices in the U.S. include the Prime Rate, the London Inter-Bank Offered Rate (LIBOR), and the Treasury Index ("T-Bill"); other indices are in use but are less popular.

Adjustable rates transfer part of the interest rate risk from the lender to the borrower, and thus are widely used where fixed rate funding is difficult to obtain or prohibitively expensive. Since the risk is transferred to the borrower, the initial interest rate may be from 0.5% to 2% lower than the average 30-year fixed rate; the size of the price differential will be related to debt market conditions, including the yield curve.

Additionally, lenders in many markets rely on credit reports and credit scores derived from them. The higher the score, the more creditworthy the borrower is assumed to be. Favorable interest rates are offered to buyers with high scores. Lower scores indicate higher risk for the lender, and higher rates will generally be charged to reflect the (expected) higher default rates.

Fixed rate mortgage

A fixed rate mortgage (FRM) is a mortgage loan where the interest rate on the note remains the "same" through the term of the loan, as opposed to loans where the interest rate may adjust or "float." Other forms of mortgage loan include interest only mortgage, graduated payment mortgage, adjustable rate mortgage, negative amortization mortgage, and balloon payment mortgage. Please note that each of the loan types above except for a straight adjustable rate mortgage can have a period of the loan for which a fixed rate may apply.
This payment amount is independent of the additional costs on a home sometimes handled in escrow, such as property taxes and property insurance. Consequently, payments made by the borrower may change over time with the changing escrow amount, but the payments handling the principal and interest on the loan will remain the same.

Fixed rate mortgages are characterized by their interest rate (including compounding frequency, amount of loan, and term of the mortgage). With these three values, the calculation of the monthly payment can then be done.

Characteristics of a fixed Loan:

Index

All fixed rate mortgages have an interest rate tied to an index. Some common indices in the United States are:

• 11th District Cost of Funds Index (COFI)
• 12-month Treasury Average Index (MTA)
• Constant Maturity Treasury (CMT)
• National Average Contract Mortgage Rate

• 11th District Cost of Funds Index (COFI)

A monthly weighted average of the interest rates paid on checking and savings accounts offered by financial institutions operating in the states of Arizona, California and Nevada. Published on the last day of each month, the COFI represents the cost of funds for western American financial institutions. The COFI is computed using several different factors, with interest paid on savings accounts comprising the largest weighting in the average. Because of this, the index tends to exhibit low volatility and follow market interest rate changes somewhat slowly it is generally regarded as a two-month lagging indicator of market interest rates. Because it is computed using data from three western states, the COFI is primarily used in the western U.S. while the Treasury Index is the measure of choice in the east.


• 12-month Treasury Average Index (MTA)
  

This rate is updated after the Federal Reserve releases its data on the first Monday of each month. This index is the 12 month average of the monthly average yields of U.S. Treasury securities adjusted to a constant maturity of one year. In plain English, this index is calculated by averaging the previous 12 rates of the 1 Year CMT. Because this particular index is an annual average, it is steadier than the 1 Year Treasury Index. It fluctuates slightly more than the 11th District Cost of Funds, although its movements track each other very closely, as shown on our comparison charts. The terms 12 MTA (12 month treasury average) and 12 MAT (12 month average treasury) are used interchangeably.

Historical Graph

• Constant Maturity Treasury (CMT)

These indexes are the weekly or monthly average yields on U.S. Treasury securities adjusted to constant maturities.

Constant Maturity Treasuries is a set of "theoretical" securities based on the most recently auctioned "real" securities: 1-, 3-, 6-month bills, 2-, 3-, 5-, 10-, 30-year notes, and also the 'off-the-runs' in the 7- to 20-year maturity range. The Constant Maturity Treasury rates are also known as "Treasury Yield Curve Rates".

Yields on Treasury securities at "constant maturity" are interpolated by the U.S. Treasury from the daily yield curve, which is based on the closing market bid yields on actively traded Treasury securities in the over-the-counter market.

The CMT indexes are volatile and move with the market. They reflect the state of the economy, and respond quickly to economic changes. These indexes react more slowly than the CD index, but more quickly than the COF index or the MTA index.



The following CMT indexes are the most often used for ARMs:

• 1-Year Constant Maturity Treasury index (1 Yr CMT)
  This is the most widely used index. Roughly half of all ARMs are based on this index. It's used on ARMs with annual rate adjustments. It is also referred to as the 1-Year Treasury Bill (1Yr T-Bill), the 1-Year Treasury Security (1Yr T-Sec), or the 1-Year Treasury Spot index.
  
• 3-Year Constant Maturity Treasury index (3 Yr CMT)
  This index is less popular than the 1-Year CMT. ARMs based on the 3 Year CMT will adjust every three years (3 Year ARMs). It may be referred to as the 3-Year Treasury Security (3Yr T-Sec) index.
  
• 5-Year Constant Maturity Treasury index (5 Yr CMT)
  Same as the 3 Year CMT, but ARM loans indexed to the 5 Year CMT will adjust once every five years (the ARM's adjustment period is usually the same as the security's constant maturity).


Historical Graph



1 Year Constant Maturity Treasury Rate
Month	1997	1998	1999	2000	2001	2002	2003	2004	2005	2006	2007
Jan	5.61%	5.24%	4.51%	6.12%	4.81%	2.16%	1.36%	1.24%	2.86%	4.45%	5.06%
Feb	5.53%	5.31%	4.70%	6.22%	4.68%	2.23%	1.30%	1.24%	3.03%	4.68%	5.05%
Mar	5.80%	5.39%	4.78%	6.22%	4.30%	2.57%	1.24%	1.19%	3.30%	4.77%	4.92%
Apr	5.99%	5.38%	4.69%	6.15%	3.98%	2.48%	1.27%	1.43%	3.32%	4.90%	4.93%
May	5.87%	5.44%	4.85%	6.33%	3.78%	2.35%	1.18%	1.78%	3.33%	5.00%	4.91%
Jun	5.69%	5.41%	5.10%	6.17%	3.58%	2.20%	1.01%	2.12%	3.36%	5.16%
Jul	5.54%	5.36%	5.03%	6.08%	3.62%	1.96%	1.12%	2.10%	3.64%	5.22%
Aug	5.56%	5.21%	5.20%	6.18%	3.47%	1.76%	1.31%	2.02%	3.87%	5.08%
Sep	5.52%	4.71%	5.25%	6.13%	2.82%	1.72%	1.24%	2.12%	3.85%	4.97%
Oct	5.46%	4.12%	5.43%	6.01%	2.33%	1.65%	1.25%	2.23%	4.18%	5.01%
Nov	5.46%	4.53%	5.55%	6.09%	2.18%	1.49%	1.34%	2.50%	4.33%	5.01%
Dec	5.53%	4.52%	5.84%	5.60%	2.22%	1.45%	1.31%	2.67%	4.35%	4.94%
Copyright 2007 www.iMortgagesites.com

 



• National Average Contract Mortgage Rate

The index is the weighted average rate of initial mortgage interest rates paid by home buyers reported by a sample of mortgage lenders for loans closed for the last 5 working days of the month. The weights are determined by the type, size and location of the lender. The rate is based on conventional fixed and adjustable rate mortgages on previously occupied non-farm single-family homes.

The National Average Contract Mortgage Rate is derived from the Federal Housing Finance Board's Monthly Interest Rate Survey (MIRS) and is reported by the FHFB on a monthly basis.

Many lenders use this rate to reset the interest rate on ARMs. In the early 1980s, it was the only index rate that federally chartered savings and loan associations could use as an adjustable rate mortgage index.

The full name of the index is: 'National Average Contract Mortgage Rate For the Purchase of Previously Occupied Homes By Combined Lenders'. The index is also sometimes referred to as the National Mortgage Contract Interest Rate.

• The index rate was calculated for loans closed during the first 5 working days of the month up through October 1991.
• Prior to October 1989, the Monthly Interest Rate Survey was conducted by the former Federal Home Loan Bank Board (FHLBB).

Banks may publish a prime lending rate which is used as the index. The index is then created as the rate plus some margin. To apply an index on a rate plus margin basis means that the interest rate will equal the underlying index plus a margin. The margin is specified in the note.

Terminology

• Fully Indexed Rate-The price of the FRM as calculated by adding Index + Margin = Fully Indexed Rate. This is the interest rate for the life of the loan.
• Term-The length of time of the loan. The number of payments is independent of this term, so a 30-year term would have 30 payments for a yearly payment plan, but 360 payments for a common monthly plan.

Popularity

Fixed rate mortgages are the most classic form of loan for home and product purchasing in the United States. The most common terms are 15-year and 30-year mortgages, but shorter terms are available, and 40-year and 50-year mortgages are now available (common in areas with high priced housing, where even a 30-year term leaves the mortgage amount out of reach of the average family).

Pricing

Fixed rate mortgages are usually more expensive than adjustable rate mortgages. Due to the inherent interest rate risk, long-term fixed rate loans will tend to be at a higher interest rate than short-term loans. The difference in interest rates between short and long-term loans is known as the yield curve, which generally slopes upward (longer terms are more expensive). The opposite circumstance is known as an inverted yield curve and is relatively infrequent.

The fact that a fixed rate mortgage has a higher starting interest rate does not indicate that this is a worse form of borrowing compared to the adjustable rate mortgages. If interest rates rise, the ARM cost will be higher while the FRM will remain the same. In effect, the lender has agreed to take the interest rate risk on a fixed rate loan. Some studies have shown that the majority of borrowers with adjustable rate mortgages save money in the long term, but that some borrowers pay more. The price of potentially saving money, in other words, is balanced by the risk of potentially higher costs. In each case, a choice would need to be made based upon the loan term, the current interest rate, and the likelihood that the rate will increase or decrease during the life of the loan.

Prepayment

Fixed rate mortgages, like other types of mortgage, may offer the ability to prepay principal (or capital) early without penalty. Early payments of part of the principal will reduce the total cost of the loan (total interest paid), and will shorten the amount of time needed to pay off the loan. Early payoff of the entire loan amount through refinancing is sometimes done when interest rates drop significantly.

Adjustable rate mortgage

An adjustable rate mortgage (ARM), variable rate mortgage or floating rate mortgage is a mortgage loan where the interest rate on the note is periodically adjusted based on an index. This is done to ensure a steady margin for the lender, whose own cost of funding will usually be related to the index. Consequently, payments made by the borrower may change over time with the changing interest rate (alternatively, the term of the loan may change). This is not to be confused with the graduated payment mortgage, which offers changing payment amounts but a fixed interest rate. Other forms of mortgage loan include interest only mortgage, fixed rate mortgage, negative amortization mortgage, and balloon payment mortgage. Adjustable rates transfer part of the interest rate risk from the lender to the borrower. They can be used where unpredictable interest rates make fixed rate loans difficult to obtain. The borrower benefits if the interest rate falls and loses out if interest rates rise.

Adjustable rate mortgages are characterized by their index and limitations on charges (caps). In U.S & many countries, adjustable rate mortgages are the norm, and in such places, may simply be referred to as mortgages.

Characteristics of the ARM loans

Index

Variable or adjustable loan is loan whose interest rate, and accordingly monthly payments, fluctuate over the period of the loan. With this type of mortgage, periodic adjustments based on changes in a defined index are made to the interest rate. The index for your particular loan is established at the time of application. All adjustable rate mortgages have an adjusting interest rate tied to an index. Six common indices in the United States are:

Well known ARM indexes include:

• Constant Maturity Treasury (CMT)
• Treasury Bill (T-Bill)
• 12-Month Treasury Average (MTA or MAT)
• Certificate of Deposit Index (CODI)
• 11th District Cost of Funds Index (COFI)
• Cost of Savings Index (COSI)
• London InterBank Offering Rates (LIBOR)
• Certificates of Deposit (CD) Indexes
• Bank Prime Loan (Prime Rate)
• Fannie Mae's Required Net Yield (RNY)
• National Average Contract Mortgage Rate

• Constant Maturity Treasury (CMT)

These indexes are the weekly or monthly average yields on U.S. Treasury securities adjusted to constant maturities.

Constant Maturity Treasuries is a set of "theoretical" securities based on the most recently auctioned "real" securities: 1-, 3-, 6-month bills, 2-, 3-, 5-, 10-, 30-year notes, and also the 'off-the-runs' in the 7- to 20-year maturity range. The Constant Maturity Treasury rates are also known as "Treasury Yield Curve Rates".

Yields on Treasury securities at "constant maturity" are interpolated by the U.S. Treasury from the daily yield curve, which is based on the closing market bid yields on actively traded Treasury securities in the over-the-counter market.

The CMT indexes are volatile and move with the market. They reflect the state of the economy, and respond quickly to economic changes. These indexes react more slowly than the CD index, but more quickly than the COF index or the MTA index.

The following CMT indexes are the most often used for ARMs:

• 1-Year Constant Maturity Treasury index (1 Yr CMT)
  This is the most widely used index. Roughly half of all ARMs are based on this index. It's used on ARMs with annual rate adjustments. It is also referred to as the 1-Year Treasury Bill (1Yr T-Bill), the 1-Year Treasury Security (1Yr T-Sec), or the 1-Year Treasury Spot index.
• 3-Year Constant Maturity Treasury index (3 Yr CMT)
  This index is less popular than the 1-Year CMT. ARMs based on the 3 Year CMT will adjust every three years (3 Year ARMs). It may be referred to as the 3-Year Treasury Security (3Yr T-Sec) index.
• 5-Year Constant Maturity Treasury index (5 Yr CMT)
  Same as the 3 Year CMT, but ARM loans indexed to the 5 Year CMT will adjust once every five years (the ARM's adjustment period is usually the same as the security's constant maturity).
  

Historical Graph

• Treasury Bill (T-Bill)

  These indexes are based on the results of auctions that the U.S. Treasury holds for its Treasury bills, notes and bonds. Treasury bills are issued by the U.S. government with maturities of 1, 3 and 6 months (4-week, 13-week, 26-week bills or 28-day, 91-day, 182-day bills) in order to pay for the national debt and other expenses. The 3- and 6-month Treasury bills are auctioned every Monday and the resulting figures are released to the public the next day. Treasury bill auction results provide the discount rate, investment yield, and price for recently auctioned bills.

  The discount rate is an annualized rate of return based on the par value of the bills and is calculated on a 360-day basis. The investment yield, or coupon-equivalent yield, is calculated on a 365-day basis and is an annualized rate based on the purchase price of the bills and reflects the actual yield to maturity.

  

  Treasury bills can be bought at original issue or on the secondary market. At original issue, the Treasury Department sells new securities to the public. On the secondary market, traders buy and sell previously issued securities.

  Following is the definition of the weekly 6-Month T-Bill index (Auction High):

  The Weekly 6-Month T-Bill (Auction High) Mortgage (ARM) Index is the discount rate for the 26-week Treasury Bill bought at original issue (at the most recent auction of U.S. Treasury bills). The current value generally reflects the previous week-ending date (previous Friday).

  T-Bill indexes have both weekly and monthly values. Monthly values are averages of the past month's weekly T-Bill rates.

  The monthly 6-Month Treasury Bill index (6-MoT-Bill) is the most often used. ARMs tied to the 6-Month T-Bill usually adjust once every six months. The Treasury Bill indexes move with the market and respond quickly to economic changes like the CMT indexes. The following graph reflects the movement of the 3-, and 6-Month monthly Treasury Bills and compares them with the monthly 1-Year CMT index.

• 12-month Treasury Average Index (MTA)

  This rate is updated after the Federal Reserve releases its data on the first Monday of each month. This index is the 12 month average of the monthly average yields of U.S. Treasury securities adjusted to a constant maturity of one year. In plain English, this index is calculated by averaging the previous 12 rates of the 1 Year CMT. Because this particular index is an annual average, it is steadier than the 1 Year Treasury Index. It fluctuates slightly more than the 11th District Cost of Funds, although its movements track each other very closely, as shown on our comparison charts. The terms 12 MTA (12 month treasury average) and 12 MAT (12 month average treasury) are used interchangeably.

• Certificate of Deposit Index (CODI)

  The Certificate of Deposit Index (CODI) is the 12 month average* of the monthly average yields on the nationally published 3-Month Certificate of Deposit rates.
  Because this index is an annual average, it is more steady than CMT and CD indexes which are very volatile and generally considered to react quickly to change in the market. The CODI and MTA indexes generally fluctuate slightly more than the 11th District COFI, although their movements track each other very closely (as illustrated on our historical graph). The MTA, COFI and CODI-indexed ARMs work much the same way.

• 11th District Cost of Funds Index (COFI)

  A monthly weighted average of the interest rates paid on checking and savings accounts offered by financial institutions operating in the states of Arizona, California and Nevada. Published on the last day of each month, the COFI represents the cost of funds for western American financial institutions. The COFI is computed using several different factors, with interest paid on savings accounts comprising the largest weighting in the average. Because of this, the index tends to exhibit low volatility and follow market interest rate changes somewhat slowly it is generally regarded as a two-month lagging indicator of market interest rates. Because it is computed using data from three western states, the COFI is primarily used in the western U.S. while the Treasury Index is the measure of choice in the east.

• Cost of Savings Index (COSI)

  • No longer exists as an index for new mortgages
  • The new index: Wachovia Cost of Savings Index (Wachovia COSI or W-COSI)

  Since the merger of Wachovia and World Savings the Wachovia family of companies no longer uses the original COSI index for new mortgages (though it is still being published for existing mortgages until they are migrated over to the Wachovia COSI).
  
  The original COSI index (GDW COSI) was the weighted average of the rates of interest on the deposit accounts of the federally insured depository institution subsidiaries of Golden West Financial Corporation (GDW). All of the depository institution subsidiaries of Golden West Financial Corporation operated under the name World Savings.
  
  World Savings receives money from consumers in the form of deposits and lends money as home or other loans. The interest rates in effect on these deposits were the basis for the GDW COSI index. It was not based on actual interest paid, but rather the weighted annualized average of all interest rates in effect on World Savings deposit accounts on the last day of each month.

  Both the original COSI (GDW COSI) and the W-COSI (Wachovia COSI) adjust monthly and have a one-month reporting lag. They are computed on the last day of each calendar month and are announced on or near the last business day prior to the fifteenth day of the following calendar month.
  
  The Cost of Savings index considered to be among the most stable ARM indexes in the industry. It is one of the most widely used Option ARM loan indexes.
  
  Many COSI-indexed ARMs often have minimum payment change caps (usually, up to 7.5% of minimum payment amount), as well as lifetime interest rate caps (usually, about 12%) but no periodic interest rate caps creating the possibility for negative amortization.



• London Interbank offered Rate (LIBOR)

  London Interbank Offered Rate (or LIBOR, pronounced LIE-bore) is a daily reference rate based on the interest rates at which banks offer to lend unsecured funds to other banks in the London wholesale money market (or interbank market). LIBOR is the opposite of the London Interbank Bid Rate (LIBID).

  The (LIBOR) index is the weighted average rate of initial mortgage interest rates paid by home buyers reported by a sample of mortgage lenders for loans closed for the last 5 working days of the month. The weights are determined by the type, size and location of the lender. The rate is based on conventional fixed and adjustable rate mortgages on previously occupied non-farm single-family homes.

  LIBOR-indexed ARMs offer borrowers aggressive initial rates (lower than many other ARMs) and has proved to be competitive with such popular ARM indexes as the 11th District Cost of Funds, the 6-Month Treasury Bill, and the 6-Month Certificate of Deposit. With the LIBOR ARMs borrowers are generally protected from wide fluctuations in interest rates by periodic and lifetime interest rate caps. LIBOR ARMs usually do not have negative amortization.

  LIBOR is published by the British Bankers Association (BBA) shortly after 11:00 each day, London time, and is a filtered average of inter-bank deposit rates offered by designated contributor banks, for maturities ranging from overnight to one year. The shorter rates, i.e. up to 6 months, are usually quite reliable and tend to precisely reflect market conditions at measurement time. The actual rate at which banks will lend to one another will, however, continue to vary throughout the day. Apart from the US dollar and, of course Pound Sterling, currencies for which LIBOR is a significant reference rate currently include the Swiss Franc, the Yen6, the Canadian dollar and the Danish Krone.

• Certificates of Deposit (CD) Indexes

  These indexes are averages of the secondary market interest rates on nationally traded Certificates of Deposit. The Certificates of Deposit, also known as CDs, are usually issued by banks and other financial institutions. They pay a fixed rate of interest for a specific period of time.

  The Certificates of Deposit of various maturities, including 1-Month, 3-Month, 6-Month and 1-Year, are used as ARM indexes. The 6-Month Certificate of Deposit (6-Mo CD) is the most popular of the CD indexes.

  The 12-month moving average of the monthly 3-Month CD is called CODI.

  The CD indexes are very volatile and generally considered to react quickly to change in the market, which is good for you if rates are falling but not good for you if rates are rising. Look at how the 6-Month CD changes:



• Bank Prime Loan (Prime Rate)

  
  prime rate

  The minimum interest rate charged by a commercial bank on short-term business loans to large, best-rated customers or corporations.

  Also called Prime, Prime Interest Rate, Prime Lending rate.
  
  Historically, in North American banking, the prime rate was the interest rate charged by lenders to borrowers whom they considered most creditworthy, although this is no longer the case. The prime rate varies little among banks, and adjustments are generally made by banks at the same time, although this does not happen with great frequency. The prime rate is currently 8.25% in the United States (verified May 2, 2007), according to data published by the Federal Reserve Bank of Saint Louis. Canadian prime rate is currently 6.00% by Bank of Canada (verified May 2, 2007). The prime rate is one of the ways the central bank, such as the Federal Reserve, uses to control the spending habits of consumers.
  
  Overview of the Prime Rate
  
  In general, the prime rate runs approximately 300 basis points (3 percentage points) above the Federal Funds Rate, the interest rate that banks charge to each other for overnight loans made to fulfill reserve funding requirements. (The Federal funds rate plus a much smaller increment is frequently used for lending to the most creditworthy borrowers today, as is LIBOR, the London Interbank Offered Rate.) The Federal Open Market Committee (FOMC) meets eight times per year wherein they set a target for the federal funds rate. Other rates, including the Prime Rate, derive from this base rate.
  
  The most commonly recognized prime rate index is the Wall Street Journal Prime Rate (WSJ Prime Rate), published in the Wall Street Journal. Unlike other indexed rates, the prime rate does not change on a regular basis; rather, it changes whenever banks need to alter the rates at which borrowers obtain funds. The WSJ defines the prime rate as "The base rate on corporate loans posted by at least 75% of the nation's 30 largest banks." It has been speculated though that this is no longer the real definition, (and that the prime rate is simply the fed funds target rate + 3) because most corporate loans are indexed to LIBOR.
  When 23 out of 30 of the United States' largest banks change their prime rate, the WSJ prints a composite prime rate change.
  

  
  Uses of the Prime Rate
  
  The Prime Rate is used often in calculating mortgages and other variable rate loans. It is used in the calculation of some private student loans. Many credit cards with variable
  The Prime Rate is the interest rate charged by banks for short-term loans to their most creditworthy customers whose credit standing is so high that little risk to the lender is involved. Only a small percentage of customers qualify for the prime rate, which tends to be the lowest going interest rate and thus serves as a basis for other, higher risk loans.
  The rate is almost always the same amongst major banks. Adjustments to the prime rate are made by banks at the same time; although, the prime rate does not adjust on any regular basis. The prime rate is not very volatile index however it generally rises quickly but declines very slowly.
  
  Many home-equity loans and lines of credit are tied to the prime rate as published in the Wall Street Journal. The Journal number is derived from the rate posted by at least 75 percent of the 30 largest U.S. banks.

• Fannie Mae's Required Net Yield (RNY)

  Strictly speaking, this is not an ARM index, however it is included here because this yield is frequently used as a basis for converting an adjustable rate mortgage to a fixed rate mortgage. Fannie Mae has many different yields.
  
  Fannie Mae, a federally chartered, shareholder-owned company, is the nation's largest source of funds for mortgages. It purchases mortgages from lenders, freeing up cash so the lenders can make more loans.
  
  To determine exactly which Fannie Mae yield your mortgage is tied to, you should contact your current mortgage lender or look in your mortgage note. The most popular yield for 30-year fixed rate mortgages is the 60-day delivery RNY -- the minimum yield that Fannie Mae require on any given day for 30-year fixed rate mortgages delivered for sale to Fannie Mae by lenders within 60 days.

• National Average Contract Mortgage Rate

  The index is the weighted average rate of initial mortgage interest rates paid by home buyers reported by a sample of mortgage lenders for loans closed for the last 5 working days of the month. The weights are determined by the type, size and location of the lender. The rate is based on conventional fixed and adjustable rate mortgages on previously occupied non-farm single-family homes.
  
  The National Average Contract Mortgage Rate is derived from the Federal Housing Finance Board's Monthly Interest Rate Survey (MIRS) and is reported by the FHFB on a monthly basis.
  Many lenders use this rate to reset the interest rate on ARMs. In the early 1980s, it was the only index rate that federally chartered savings and loan associations could use as an adjustable rate mortgage index.
  
  The full name of the index is: 'National Average Contract Mortgage Rate For the Purchase of Previously Occupied Homes By Combined Lenders'. The index is also sometimes referred to as the National Mortgage Contract Interest Rate.

  • The index rate was calculated for loans closed during the first 5 working days of the month up through October 1991.
  • Prior to October 1989, the Monthly Interest Rate Survey was conducted by the former Federal Home Loan Bank Board (FHLBB).
  
  Banks may publish a prime lending rate which is used as the index. The index is then created as the rate plus some margin. To apply an index on a rate plus margin basis means that the interest rate will equal the underlying index plus a margin. The margin is specified in the note.

What are the Limitations on charges (caps)?

Any mortgage where payments made by the borrower may increase over time brings with it the risk of financial hardship to the borrower. To limit this risk, limitations on charges-known as caps in the industry-are a common feature of adjustable rate mortgages. Caps typically apply to three characteristics of the mortgage:

• frequency of the interest rate change
• periodic change in interest rate
• total change in interest rate over the life of the loan, sometimes called life cap

For example, a given ARM might have the following types of caps:

Interest rate adjustment caps:

• interest adjustments made every 6 months, typically 1% per adjustment, 2% total per year
• interest adjustments made only once a year, typically 2% maximum
• interest rate may adjust no more than 1% in a year

Mortgage payment adjustment caps:

• maximum mortgage payment adjustments of 5% a year, which is common with pay-option / negative amortization loans

Life of loan interest rate adjustment caps:

• total interest rate adjustment limited to 5% of the life of the loan. Most common is 6% lifetime caps.

Caps on the periodic change in interest rate may be broken up into one limit on the first periodic change and a separate limit on subsequent periodic change, for example 5% on the initial adjustment and 2% on subsequent adjustments.

Another common cap is a limitation on the maximum monthly payment expressed in absolute rather than relative terms, for example $1000 a month.

ARMs which allow negative amortization may have a payment adjustment frequency which differs from the interest rate adjustment frequency. For example, the interest rate may be adjusted every six months, but the payment amount only once every 12 months.

Cap structure is sometimes expressed as initial adjustment cap / subsequent adjustment cap / life cap, for example 2/2/5 for a loan with a 2% cap on the initial adjustment, a 2% cap on subsequent adjustments, and a 5% cap on total interest rate adjustments. When only two values are given, this indicates that the initial change cap and periodic cap are the same. For example, a 2/2/5 cap structure may sometimes be written simply 2/5.

What are the Reasons Banks Prefer ARMs?

In many countries, banks or similar financial institutions are the primary originators of mortgages. For banks that are funded from customer deposits, the customer deposits will typically have much shorter terms than residential mortgages. If a bank were to offer large volumes of mortgages at fixed rates but to derive most of its funding from deposits (or other short-term sources of funds), the bank would have an asset-liability mismatch: in this case, it would be running the risk that the interest income from its mortgage portfolio would be less than it needed to pay its depositors. In the United States, some argue that the savings and loan crisis was in part caused by this problem, that the savings and loans companies had short-term deposits and long-term, fixed rate mortgages, and were caught when "Paul Volcker" raised interest rates in the early 1980s.

To avoid this risk, many mortgage originators will sell or securitize their mortgages. Banking regulators pay close attention to asset-liability mismatches to avoid such problems, and place tight restrictions on the amount of long-term fixed-rate mortgages that banks may hold (in relation to their other assets).

In this perspective, banks and other financial institutions offer adjustable rate mortgages because it reduces risk and matches their sources of funding.

For the borrower, adjustable rate mortgages may be less expensive, but at the price of higher risk borne by the borrower. In 'most' situations, short-term borrowing is less expensive than long-term borrowing, due to the slope of the yield curve. If rates are expected to rise, however, or the yield curve is sloped down (long-term money is less expensive than short-term money) borrowers may end up paying more over the life of the mortgage loan.

What are ARM Variants?

Hybrid ARMs

A hybrid adjustable-rate mortgage (ARM) is one where the interest rate on the note is fixed for a period of time, then floats thereafter. The "hybrid" refers to the blend of fixed rate and adjustable rate characteristics found in hybrid ARMs. Hybrid ARMs are referred to by their initial fixed period and adjustment periods, for example 3/1 for an ARM with a 3-year fixed period and subsequent 1-year rate adjustment periods. The date that a hybrid ARM shifts from a fixed-rate payment schedule to an adjusting payment schedule is known as the reset date. After the reset date, a hybrid ARM floats at a margin over a specified index just like any ordinary ARM.

The popularity of hybrid ARMs has significantly increased in recent years. In 1998, the percentage of hybrids relative to 30-year fixed rate mortgages was less than 2%; within 6 years, this increased to 27.5%.

Like other adjustable-rate products, hybrid ARMs transfer some interest rate risk from the lender to the borrower, thus allowing the lender to offer a lower note rate.

Option ARMs

An "option ARM" is a loan where the borrower has the option of making a specified minimum payment, an interest-only payment, or a 15-year or 30-year fixed rate payment in a given month.

Four options for a Payment:

1. Minimum Payment
2. Interest Only Payment
3. 15 year fixed Payment
4. 30 year fixed Payment

This type of loan is also known and advertised as the "pick a payment" or "pay-option" loan.

When a borrower makes a payment that is less than the interest payment, there is negative amortization, where the unpaid interest is added back onto the principal balance.

Option ARMs are popular because they are usually offered with a very low initial interest rate (a so-called "teaser rate") and a low minimum payment, which permits borrowers to qualify for a much larger loan than would otherwise be possible. When pricing an Option ARM, never focus on the Start Rate of 1% or 2%, consider only the Fully Indexed Rate (FIR) which is the Margin and the current Index being used (12-MTA, LIBOR, etc.).

Option ARMs are best suited to people in fields with sporadic income, such as some self-employed people or those in a highly seasonal business. For example, someone who makes the majority of their income around the winter holiday season, but who earns minimal income during the following few months may wish to pay the full payment during their busy season, but drop back to the interest-only payment or the minimum during a period of reduced earnings. This gives greater flexibility to how the mortgage is paid. With a fixed-payment loan, if the borrower was unable to meet the fixed payment, they would risk late fees or foreclosure.

The main risk of an Option ARM is "payment shock", when the negative amortization reaches a stated maximum, at which point the minimum payment will be raised to a level that amortizes the loan balance.

The function of the loan that can cause this payment shock is called the "Recast" cap. The recast will happen when the original loan balance reaches 110% to 125% of the original loan balance due to negative amortization of making the minimum payment.

For example: a $200,000 with a 110% recast cap will adjust to a fully indexed, fully amortized payment based on the remaining term of the loan when the negative amortization add to the loan balance reaches $220,000. If it was a 125% recast this will happen when loan balance reaches $250,000.

Obviously the higher the recast cap the longer it will take for the recast to take place and the more negative amortization can be added to the loan balance.

Another risk, as with any loan with potential negative amortization, is that the increased loan balance will reduce or eliminate the borrower's equity in the financed property, or if the value of the property declines, increase the chance that he won't be able to sell the property for an amount that will repay the loan.
Historically, option ARM mortgages have been used effectively to minimize income taxes and maximize mortgage interest deductions by high net worth homeowners whose earnings are primarily derived from passive or investment income. By making minimum payments over the course of a year, these borrowers are able to defer the majority of the income required to service their mortgage debt to the end of the year, allowing income brought in as a long term capital gain, and taxable at a favorable rate, to be used in making lump sum interest payments. High net worth individuals and real estate investors also have a long history of utilizing the negative amortization characteristics of these mortgages to their advantage to avoid taxation entirely on gains in real estate, by refinancing regularly to "take profits" from illiquid residential and commercial real estate equity.

Option ARM mortgages are increasingly available in Hybrid, or temporarily Fixed Rate varieties, from 3 to 10 years, mitigating certain negative amortization characteristics of the popular Adjustable Rate variety. Largely as a result of yield curve inversion, a handful of banks have introduced 30 year fixed rate mortgages with option ARM style minimum payments.

ARM Terminology

• X/Y - Hybrid ARMs are often referred to in this format, where X is the number of years during which the initial interest rate applies prior to first adjustment (common terms are 3, 5, 7, and 10 years), and Y is the interval between adjustments (common terms are 1 for one year and 6 for six months). As an example, a 5/1 ARM means that the initial interest rate applies for five years (or 60 months, in terms of payments), after which the interest rate is adjusted annually. (Adjustments for escrow accounts, however, do not follow the 5/1 schedule; these are done annually.)
• Fully Indexed Rate - The price of the ARM as calculated by adding Index + Margin = Fully Indexed Rate. This is the interest rate your loan would be at without a Start Rate (the introductory special rate for the initial fixed period). This means the loan would be higher if it was adjusting, typically, 1-3% higher than the fixed rate. Calculating this is important for ARM buyers, since it helps predict the future interest rate of the loan.
• Margin - For ARMs where the index is applied to the interest rate of the note on an "index plus margin" basis, the margin is the difference between the note rate and the index on which the note rate is based expressed in percentage terms. This is not to be confused with profit margin. The lower the margin the better the loan is as the maximum rate will increase less at each adjustment. Margins will vary between 2%-7%.
• Index - A published financial index such as LIBOR used to periodically adjust the interest rate of the ARM.
• Start Rate - The introductory rate provided to purchasers of ARM loans for the initial fixed interest period.
• Period - The length of time between interest rate adjustments. In times of falling interest rates, a shorter period benefits the borrower. On the other hand, in times of rising interest rates, a longer period benefits the borrower.
• Floor - A clause that sets the minimum rate for the interest rate of an ARM loan. Loans may come with a Start Rate = Floor feature, but this is primarily for Non-Conforming (aka Sub-Prime or Program Lending) loan products. This prevents an ARM loan from ever adjusting lower than the Start Rate. An "A Paper" loan typically has either no Floor or 2% below start.
• Payment Shock - Industry term to describe the severe (unexpected or planned for by borrower) upward movement of mortgage loan interest rates and its effect on borrowers. This is the major risk of an ARM, as this can lead to severe financial hardship for the borrower.
• Cap - Any clause that sets a limitation on the amount or frequency of rate changes.

What are Loan Caps?

Loan caps provide payment protection against payment shock, and allow a measure of interest rate certainty to those who gamble with initial fixed rates on ARM loans. There are three types of Caps on a typical First Lien Adjustable Rate Mortgage or First Lien Hybrid Adjustable Rate Mortgage.

Initial Adjustment Rate Cap

The majority of loans have a higher cap for initial adjustments that's indexed to the initial fixed period. In other words, the longer the initial fixed term, the more the bank would like to potentially adjust your loan. Typically, this cap is 2-3% above the Start Rate on a loan with an initial fixed rate term of 3 years or lower and 5-6% above the Start Rate on a loan with an initial fixed rate term of 5 years or greater.

Rate Adjustment Cap

This is the maximum amount by which an Adjustable Rate Mortgage may increase on each successive adjustment. Similar to the initial cap, this cap is usually 1% above the Start Rate for loans with an initial fixed term of 3 years or greater and usually 2% above the Start Rate for loans that have an initial fixed term of 5 years or greater.

Lifetime Cap

Most First Mortgage loans have a 5% or 6% Life Cap above the Start Rate (this ultimately varies by the lender and credit grade).

Industry Shorthand for ARM Caps

Inside the business caps are expressed most often by simply the 3 numbers involved that signify each cap. For example, a 5/1 Hybrid ARM may have a cap structure of 5/2/5 (5% initial cap, 2% adjustment cap and 5% lifetime cap) and insiders would call this a 5-2-5 cap. Alternately a 1 year arm might have a 1/1/6 cap (1% initial cap, 1% adjustment cap and 6% lifetime cap) known as a 1-1-6, or alternately expressed as a 1/6 cap (leaving out one digit signifies that the initial and adjustment caps are identical).

Negative amortization ARM caps

See the complete article for the type of ARM that Negative amortization loans are by nature. Higher risk products, such as First Lien Monthly Adjustable loans with Negative amortization and Home Equity Lines of Credit aka HELOC have different ways of structuring the Cap than a typical First Lien Mortgage. The typical First Lien Monthly Adjustable loans with Negative amortization loan have a life cap for the underlying rate (aka "Fully Indexed Rate") between 9.95% and 12% (maximum assessed interest rate). Some of these loans can have much higher rate ceilings. The fully indexed rate is always listed on the statement, but borrowers are shielded from the full effect of rate increases by the minimum payment, until the loan is recast, which is when principal and interest payments are due that will fully amortize the loan at the fully indexed rate.

Home Equity Lines of Credit HELOC

Since HELOCs are intended by banks to primarily sit in second lien position, they normally are only capped by the maximum interest rate allowed by law in the state wherein they are issued. For example, Florida currently has an 18% cap on interest rate charges. These loans are risky in the sense that to lenders, they are practically a credit card issued to the borrower, with minimal security in the event of default. They are risky to the borrower in the sense that they are mostly indexed to the Wall Street Journal Prime Rate, which is considered a Spot Index, or a financial indicator that is subject to immediate change (as are the loans based upon the Prime Rate). The risk to borrower being that a financial situation causing the Federal Reserve to raise rates dramatically) would effect an immediate rise in obligation to the borrower, up to the capped rate.

Pricing of the ARM Mortgage?

Adjustable rate mortgages are typically, but not always, less expensive than fixed-rate mortgages. Due to the inherent interest rate risk, long-term fixed rates will tend to be higher than short-term rates (which are the basis for variable-rate loans and mortgages). The difference in interest rates between short and long-term loans is known as the yield curve, which generally slopes upward (longer terms are more expensive). The opposite circumstance is known as an inverted yield curve and is relatively infrequent.

The fact that an adjustable rate mortgage has a lower starting interest rate does not indicate what the future cost of borrowing will be (when rates change). If rates rise, the cost will be higher; if rates go down, the rate will be lower. In effect, the borrower has agreed to take the interest rate risk. Some studies have shown that

on average, the majority of borrowers with adjustable rate mortgages save money in the long term; but they have also demonstrated that some borrowers pay more. The price of potentially saving money, in other words, is balanced by the risk of potentially higher costs.

Prepayment

Adjustable rate mortgages, like other types of mortgage, may offer the ability to repay principal (or capital) early without penalty. Early payments of part of the principal will reduce the total cost of the loan (total interest paid), and will shorten the amount of time needed to pay off the loan. Early payoff of the entire loan amount through refinancing is sometimes done when interest rates drop significantly.

Criticism

Adjustable rate mortgages are sometimes sold to unsophisticated consumers who are unlikely to be able to repay the loan should interest rates rise. In the United States, extreme cases are characterized by the Consumer Federation of America as predatory loans. Protections against interest rate rises include

1. a possible initial period with a fixed rate (which gives the borrower a chance to increase his/her annual earnings before payments rise);
2. a maximum (cap) that interest rates can rise in any year (if there is a cap, it must be specified in the loan document); and
3. a maximum (cap) that interest rates can rise over the life of the mortgage (this also must be specified in the loan document).

What are the types of Mortgages?

What is an Assumed mortgage?

In real estate an assumed mortgage occurs when a buyer of a real property is transferred all the obligations of the seller's mortgage.
The buyer assumes all the obligations under the mortgage, just as if the loan had been made to the buyer. The major driving force behind assumptions is the lower interest rate on the assumed mortgage relative to current market rates. This method is frequently used when the buyer can not get a better interest rate than the seller currently has. In refinance process one can assume the loan from the current owner of a property. It is commonly used between the family members; however, the person who is to assume the property or loan of the property must make at least 6 payments for the mortgage before he/she can qualify himself/herself to assume the loan of that particular property.

What is a Balloon mortgage?

A balloon payment mortgage is a mortgage which does not fully amortize over the term of the note, thus leaving a balance due at maturity. The final payment is called a balloon payment because of its large size. Balloon payment mortgages are more common in commercial real estate than in residential real estate. A balloon payment mortgage may have a fixed or a floating interest rate.
An example of a balloon payment mortgage is the 7-year Fannie Mae Balloon, which features monthly payments based on a 30-year amortization. In the United States, the amount of the balloon payment must be stated in the contract if Truth-in-Lending provisions apply to the loan.

What is a Blanket loan?

A blanket loan, or blanket mortgage, is a type of loan used to fund the purchase of more than one piece of real property. Blanket loans are popular with builders and developers who buy large tracts of land, then subdivide them to create many individual parcels to be gradually sold one at a time. Rather than securing a new mortgage each time a portion of the development is sold, the borrower uses the blanket loan to buy them all. Once a parcel is sold, a portion of the mortgage is released, with the rest of the mortgage remaining intact.

Traditional mortgages typically have a "due-on-sale clause", which stipulates that if property secured by the mortgage is sold, the entire outstanding mortgage debt must be paid in full immediately. With a blanket mortgage, a "release clause" allows the sale of portions of the secured property and corresponding partial repayment of the loan. This is done to facilitate purchases and sales of multiple units of property with the convenience of a single mortgage.

What is a Bridge loan?

A bridge loan (or swing loan) is a type of short-term loan in the financial industry. Bridge loans are typically taken out for a period of 2 weeks to 3 years in order to finance projects. Bridge loans are often used for commercial real estate purchases, to quickly close on a property, retrieve real estate from foreclosure, and to take advantage of a short-term financing opportunity in order to secure long term financing. Speed is a bridge loan's number one asset.

A bridge loan is similar to a hard money loan. The primary difference between the two is that a hard money loan can refer to a distressed property or situation. A bridge loan may be simply a similar or higher interest loan that provides interim financing for an individual or business until permanent or the next stage of financing can be issued. For example a land loan for an investor might only cover 50% of the property value. A bridge loan might lend additional funding during the permit phase. The construction loan will be issued usually after the permits are issued and approved. Then the end loan or traditional mortgage will be issued after the certificates of completion are issued by the local building department.

Example: If you are trying to convert an apartment complex into condos and a bank will provide you with a sum of money only after a five month period, you might take out a bridge loan to finance your project while you are waiting for the bank.
Bridge loans may also be funded with hard money loans. Bridge loans are also commonly used by consumers for the purchase of real estate. In corporate finance, bridge loans are often used by companies to avoid running out of fund between larger securities offerings.

What is a Buy-down mortgage?

A buy-down is a mortgage financing technique where the buyer attempts to obtain a lower interest rate for at least the first few years of the mortgage. The seller of the property usually provides payments to the mortgage lending institution, which, in turn, lowers the buyer's monthly interest rate and therefore monthly payment. This is typically done for a period of about one to five years. In a seller's market the seller might raise the purchase price to compensate for the costs of the buydown but in most markets it would not be to their advantage to use a buydown as an enticement if they are going to offset the benefit by raising the price. In most cases, the buydown does not even involve the seller. It is an arrangement between the lender and the buyer.You may also use the buydown option on a refinance.

What is an Equity loan?

An equity loan is a mortgage placed on real estate in exchange for cash to the borrower. For example, if a person owns a home worth $100,000, but does not currently have a lien on it, they may take an equity loan up to 90% loan to value (LTV) or $90,000 in cash in exchange for a lien on title placed by the lender of the equity loan.

Many lending institutions require the borrower to repay only an interest component of the loan each month (calculated daily, and compounded to the loan once each month). The borrower can apply any surplus funds to the outstanding loan principal at any time, reducing the amount of interest calculated from that day onwards. Some loan products also allow the possibility to redraw cash up to the original LTV, potentially perpetuating the life of the loan beyond the original loan term. The rate of interest applied to equity loans is much lower than that applied to unsecured loans, such as credit card debt.

What is Foreign National mortgage?

A mortgage to a non resident is called a Foreign National Mortgage loan. A foreign national who is not a resident of the United States will in many cases seek to own real estate. Financing real estate is generally done by US mortgage companies and banks to United States citizens.

Lenders also offer loans to non citizens. They may be resident aliens, temporary residents or other classifications of either temporary or permanent status.

Down payment requirements are usually higher for foreign national borrowers. The minimum down payment is usually 20% of the total purchase price of the property. This is also referred to as an 80% Loan to Value "LTV" loan.

What is a Graduated payment mortgage loan?

A graduated payment mortgage loan, often referred to as GPM, is a mortgage with low initial monthly payments which gradually increase over a specified time frame. These plans are mostly geared towards young men and women who cannot afford large payments now, but can realistically expect to do better financially in the future. For instance a medical student who is just about to finish medical school might not have the financial capability to pay for a mortgage loan, but once he graduates, it is more than probable that he will be earning a high income. It is a form of negative amortization loan.

• GPMs are available in 30 year and 15 year amortization, and for both conforming and jumbo mortgage. Over a period of time, typically 5 to 15 years, the monthly payments increase every year according a predetermined percentage. For instance, a borrower may have a 30-year graduated payment mortgage with monthly payments that increase by 7 % every year for five years. At the end of five years, the increases stop. The borrower would then pay this new increased amount monthly for the rest of the 25-year loan term.

What is a Hard money loan?

A hard money loan is a specific type of financing in which a borrower receives funds based on the value of a specific parcel of real estate. Hard money loans are typically issued at much higher interest rates than conventional commercial or residential property loans and are almost never issued by a commercial bank or other deposit institution. Hard money is similar to a bridge loan which usually has similar criteria for lending as well as cost to the borrowers. The primary difference is that a bridge loan often refers to a commercial property or investment property that may be in transition and not yet qualifying for traditional financing. Whereas hard money often refers to not only an asset-based loan with a high interest rate, but can signify a distressed financial situation such as arrears on the existing mortgage or bankruptcy and foreclosure proceedings are occurring.

Loan Structure

A hard money loan is a species of real estate loan collateralized against the quick-sale value of the property for which the loan is made. Most lenders fund in the first lien position, meaning that in the event of a default, they are the first creditor to receive remuneration. Occasionally, a lender will subordinate to another first lien position loan; this loan is known as a mezzanine loan or second lien.

Hard money lenders structure loans based on a percentage of the quick-sale value of the subject property. This is called the loan-to-value or LTV ratio and typically hovers between 60-70% of the market value of the property. For the purpose of determining an LTV, the word "value" is defined as "today's purchase price." This is the amount a lender could reasonably expect to realize from the sale of the property in the event that the loan defaults and the property must be sold in a one- to four-month timeframe. This value differs from a market value appraisal, which assumes an arms-length transaction in which neither buyer nor seller is acting under duress.

Below is an example of how a commercial real estate purchase might be structured by a hard money lender:

• 65% Hard money (Conforming loan)
• 20% Borrower equity (cash or additional collateralized real estate)
• 15% Seller carry back loan or other subordinated (mezzanine) loan

What are Jumbo Mortgages?

In the United States, a jumbo mortgage is a mortgage with a loan amount above the industry-standard definition of conventional conforming loan limits. This standard is set by the two largest secondary market lenders, Fannie Mae and Freddie Mac. Loans above the conforming limits may be offered by seller servicers of these wholesale institutions, as well as Wall Street conduits who provide warehouse financing for mortgage lenders. The loan amounts reflect average loan sizes nationwide. Jumbo mortgages apply when agency (FNMA and FHLMC) limits don't cover the full loan amount. Fannie Mae (FNMA) and Freddie Mac (FHLMC) are large agencies that purchase the bulk of residential mortgages in the U.S. They set a limit on the maximum dollar value of any mortgage they will purchase from an individual lender. As of 2006, the limit is $417,000, or $625,500 in Alaska, Hawaii, Guam, and the U.S. Virgin Islands. Other large investors, such as insurance companies and banks, step in to fill the need, with maximum mortgage amounts going to the $1 million or $2 million range. A loan in excess of $650,000 is referred to as a super jumbo mortgage. The average interest rates on jumbo mortgages are typically greater than is normal for conforming mortgages, and vary depending on property types and mortgage amount.

Risk

Jumbo mortgage loans are a higher risk for lenders. This is because if a jumbo mortgage loan defaults, it is harder to sell a luxury residence quickly for full price. Luxury prices are more vulnerable to market highs and lows. That is one reason lenders prefer to have a higher down payment from jumbo loan seekers. Jumbo home prices can be more subjective and not as easily sold to a mainstream borrower, therefore many lenders may require two appraisals on a jumbo mortgage loan.

The interest rate charged on jumbo mortgage loans is generally higher than a loan that is conforming, due to the slightly higher risk to the lender. It can vary but is generally 0.25% to 0.5% higher.

Loan options

Jumbo mortgage loan options are similar to traditional loan programs. They simply require a slightly higher down payment, usually of an additional 5% for similar program types. No-money-down programs are generally not available, but instead require a minimum of 5% down payment for a jumbo mortgage. Because the loans are large, jumbo lenders frequently offer variable loan programs to the jumbo client. The risk of an interest rate increase can result in a large dollar amount increase. Generally, adjustable rate mortgages are popular due to the low payment.

It can be more expensive to refinance a jumbo loan due to the closing costs. Some lenders will offer the service of an extension and consolidation agreement, so that a jumbo refinancer will not have to pay for mortgage tax again on the same principal balance. In other cases, title insurance companies will offer up to a 50% discount, often required by law for those refinancing within 1 year to 10 years. The largest discount is for refinancing within one year.

Some consumers seeking a jumbo mortgage choose to seek advice from a competent professional familiar with jumbo mortgage loans.

Recent trends

Due to increased housing prices, there is a large increase in the number of jumbo loan applicants. Many consumers are becoming jumbo borrowers when buying a modest ranch or Cape Cod house; this option is no longer limited to high-end luxury residences.

New loan programs are now offered to address the large increase in jumbo loan applications. Because of the steep price increases during the recent years (2000-2006), mortgage loans are required in excess of the conforming limits in most big-city areas or their surrounding suburbs. The new loans are either a 40- or even 50-year amortization, or an interest-only option. They allow the jumbo loan borrower to pay the loan back over a longer period of time, or to defer any repayment of principal for a few years-thus saving them on their monthly payment. In some cases, the banker makes a larger profit if the loan takes more than 30 years to repay.

Popular Programs Avoid Costly Private Mortgage Insurance ("PMI")

80/20 & 80/15 jumbo loan programs are very popular with new home purchasers. Because any borrower with less than a twenty percent down payment was previously subject to purchasing private mortgage insurance (PMI) to insure the lender for the higher risk, jumbo borrowers were previously paying a very large PMI fee on a loan with an LTV (loan-to-value ratio) higher than 80%.

Now, the jumbo borrower can borrow the 80% without PMI, and take a second mortgage at a slightly higher intererst rate, which does not require PMI, and hedges the risk of the first position lender at the lower interest rate.

What is Package loan/Mortgage?

A package loan is a real estate loan used to finance the purchase of both real property and personal property, such as in the purchase of a new home that includes carpeting, window coverings and major appliances.

What is a Participation Mortgage?

A participation mortgage is a mortgage wherein the lender, or mortgagee, is entitled to share in the rental or resale proceeds from a property owned by the borrower, or mortgagor. A participation mortgage may or may not require principal and interest payments, and may or may not contain a balloon payment.

For instance, Michael has a loan for a shopping center including 12 separate units. All are rented / leased and in addition to the principal and interest he pays to the lender, he is required to pay a certain percentage of the incoming funds. The lender is then participating in the income stream provided by the particular property.

What is a Reverse mortgage?

A reverse mortgage (known as lifetime mortgage in the United Kingdom) is a loan available to seniors (62 and over in the United States), and is used to release the home equity in the property as one lump sum or multiple payments.

• The homeowner's obligation to repay the loan is deferred until the owner dies, the home is sold, or the owner leaves (i.e. into aged care).
• In a typical mortgage the homeowner makes a monthly amortized payment to the lender; after each payment the equity increases within his or her property, and typically after 30 years the mortgage is paid in full and the property is released from the lender.
• In a reverse mortgage, the home owner makes no payments and all interest is added to the lien on the property. If the owner receives monthly payments, then the debt on the property increases each month.

If a property has increased in value after a reverse mortgage is taken out, it is possible to acquire a second (or third) reverse mortgage over the increased equity in the home. But in certain countries (including the United States), a reverse mortgage must be the first and only mortgage on the property.

Requirements of the Reverse Mortgages

• To qualify for a reverse mortgage in the United States:
• The borrower must be at least 62 years of age.
• There are no minimum income or credit requirements.
• Clients must not be in the bankruptcy process.
• Borrower must payoff existing mortgage
• Lower value mobile homes do not qualify for reverse mortgage.
• Borrower must seek financial counseling from a (HUD) approved source.

The counseling is a safeguard for the borrower and his/her family, to make sure the borrower completely understands what a reverse mortgage is and how one is obtained. The American Association of Retired Persons (AARP) has proposed a plan for keeping closing costs low for seniors who qualify for reverse mortgages. The plan must be approved by the federal government and is controversial for a number or reasons. One possible disadvantage is that homeowners will be limited to Bank of America, Countrywide, or Wells Fargo.

Payment(s) (loan advances)

The amount of money that an individual homeowner can receive from a reverse mortgage depends on his or her age, the Federal Housing Administration (FHA) or Fannie Mae (FNMA) appraised value of the home, and the starting interest rate (effective upon closing/finalization of the loan). The location of the home may also have an impact. There is also a type of reverse mortgage for homes valued over the maximum Fannie Mae limit. These are called "cash" accounts, and are proprietary loan products.

In a reverse mortgage in the U.S., a borrower can be paid in a lump sum, monthly (payment of advances), through an increasing line of credit, or a combination of all three. The money received (loan advances) are not taxable and do not directly affect Social Security or Medicare benefits. However, an American Bar Association guide to reverse mortgages explains that if you receive Medicaid, SSI, or other public benefits, loan advances will be counted as "liquid assets" if the money is kept in an account (savings, checking, etc.) past the end of the calendar month in which it is received. The borrower could then lose eligibility for such public programs if his or her total liquid assets (cash, generally) is then greater than those programs allow.

A borrower can elect to move available funds into a "set-aside" account, similar to a typical escrow account, to pay for his or her future property taxes and/or homeowners insurance. Currently, most reverse mortgage borrowers do not exercise this option and instead elect to be responsible for the payment of taxes and/or insurance on their own. It is important to note that the homeowner must ensure that taxes and insurance are kept current at all times. If either taxes or insurance lapse, it could result in a default on the reverse mortgage.

Costs and interest rates

The cost of getting a reverse mortgage from a private sector lender may exceed the costs of other types of mortgage or equity conversion loans. Exact costs depend on the particular reverse mortgage program that the borrower acquires. For the most popular type of reverse mortgage in the U.S., the FHA-insured Home Equity Conversion Mortgage (HECM), there is an insurance premium of 2% of the loan and a 2% origination fee in addition to normal closing costs, which are typically several thousand dollars, but vary depending on the third-party costs (appraisal fees, title searches, etc.) that must be undertaken. Thus a $250,000 loan would have $9,000 in costs beyond the normal closing costs added onto the loan at the outset.

Other programs skip the insurance premium but still require the origination fees and closing costs, and some programs waive the initial costs if the borrower borrows all or most of the maximum amount that he or she is eligible to receive. In addition, a monthly service charge (between $25 and $35) is usually added to the total amount of the loan.

In all of these cases, the costs of a reverse mortgage can typically be financed with the proceeds of the loan itself, with the costs and fees being rolled directly into the principal balance of the loan, rather than paid by the borrower in cash. While this does permit borrowers with little or no available cash to get a reverse mortgage, it means that the initial loan principal will be increased, and consequently, that the fees will begin accruing interest.

Interest rates on reverse mortgages are determined on a program-by-program basis, but are typically similar to interest rates offered by Adjustable Rate Mortgages (ARMs). All major reverse mortgage programs have adjustable interest rates that are adjusted on an annual, semi-annual, or monthly basis.

ecause reverse mortgages have no fixed duration, typically there are no reverse mortgages with fixed interest rates. There are now some new reverse mortgage programs that have fixed interest rates.

Some state and local governments offer low-cost reverse mortgages to seniors. These "public sector" loans generally must be used for specific purposes, such as paying for home repairs or property taxes, but most of them are insured by the Federal Housing Administration (FHA) and often have more favorable interest rates and fewer or no fees associated with them. These programs are typically very restrictive in terms of qualification and location, and many regions, states, and areas do not have such programs at all.

What is a Repayment Mortgage?

A repayment mortgage is a term generally used to describe a mortgage in which the monthly repayments consist of repaying the capital amount borrowed as well as the accrued interest. The mortgage statement, usually received annually, shows the amount borrowed decreases throughout the term.

The big advantage of a repayment mortgage is that at the end of the mortgage term, the full amount of the debt has been repaid. It also removes the risk of having an investment, the performance of which is dependent on the stock market. The borrower is less likely to suffer from negative equity because the mortgage balance will be reducing month on month.

As time moves on, the equity percentage in the property increases. However, in the early years the bulk of the mortgage repayments consist of the interest component, so not much of the capital is actually paid off for some time.

What is a Seasoned mortgage?

Mortgage which has been paid in a timely manner by Mortgagor, typically for no less than six months, often for more than one year. A term associated with the secondary market where lots of mortgages with similar characteristics are bought and sold in bulk.

What is a Term loan or Interest-only loan?

An interest-only loan is a loan in which for a set term the borrower pays only the interest on the principal balance, with the principal balance unchanged. At the end of the interest-only term the borrower may enter an interest-only mortgage, pay the principal, or (with some lenders) convert the loan to a principal and interest payment (or amortized) loan at his/her option.

The main alternative to capital and interest mortgage is an interest only mortgage, where the capital is not repaid throughout the term. This type of mortgage is common in the UK, especially when associated with a regular investment plan. With this arrangement regular contributions are made to a separate investment plan designed to build up a lump sum to repay the mortgage at maturity. This type of arrangement is called an investment-backed mortgage or is often related to the type of plan used: endowment mortgage if an endowment policy is used, similarly a Personal Equity Plan (PEP) mortgage, Individual Savings Account (ISA) mortgage or pension mortgage. Historically, investment-backed mortgages offered various tax advantages over repayment mortgages, although this is no longer the case in the UK. Investment-backed mortgages are seen as higher risk as they are dependent on the investment making sufficient return to clear the debt.

It is not uncommon for interest only mortgages to be arranged without a repayment vehicle, with the borrower gambling that the property market will rise sufficiently for the loan to be repaid by trading down at retirement (or when rent on the property and inflation combine to surpass the interest rate).

What are Interest-Only Mortgages?

In the United States, a five or ten year interest-only period is typical. After this time, the principal balance is amortized for the remaining term. In other words, if a borrower had a thirty-year mortgage loan and the first ten years were interest only, at the end of the first ten years, the principal balance would be amortized for the remaining period of twenty years. The practical result is that the early payments (in the interest-only period) are substantially lower than the later payments. This gives the borrower more flexibility because they are not forced to make payments towards principal. Indeed, it also enables a borrower who expects to increase their salary substantially over the course of the loan to borrow more than they would have otherwise been able to afford, or investors to generate cash flow when they might not otherwise be able to. During the interest only years of the mortgage, the loan balance will not decrease unless the borrower makes additional payments towards principal. Under a conventional amortizing mortgage, the portion of a payment that represents principal is very small in the early years (the same period of time that would be interest only). Interest only loans represent a somewhat higher risk for lenders, and therefore are subject to a slightly higher interest rate. Combined with little or no down payment, the adjustable rate (ARM) variety of interest only mortgages are sometimes indicative of a buyer taking on too much risk- especially when that buyer is unlikely to qualify under more conservative loan structures.

Because a homeowner does not build any equity in an interest-only loan they may be adversely affected by prevailing market conditions at the time they are either ready to sell the house or refinance. They may find themselves unable to afford the higher regularly amortized payments at the end of the interest only period, unable to refinance due to lack of equity and unable to sell if demand for housing has weakened. Due to the speculative aspects of relying on home appreciation which may or may not happen, many financial experts advise against interest only loans for which a borrower would not otherwise qualify for.

What is a Wraparound mortgage?

A wraparound is a way of lowering the barriers of entry to a junior lien or subordinate mortgage; it also expedites process of purchasing a home. A junior lien or subordinate mortgage is a second mortgage that generally sits behind larger first mortgage.

Here is an example of wraparound:

The seller, who has the original mortgage, sells his home with the existing first mortgage in place and a second mortgage which he "carries back" from the buyer. The mortgage he takes from the buyer is for the amount of the first mortgage, plus a negotiated amount less than or up to the sales price minus the down payment and closing costs. The seller then continues to pay the first mortgage with the proceeds of the second. Once the second mortgage is satisfied, the seller is out, but this is rarely the case.

Typically, the seller also charges a "middle" on the first mortgage. For example, one has a first mortgage at 6% and sells the whole property with a rate of 8% on a wraparound mortgage. He/she make a 2% middle on the first mortgage amount, using other people's money to make money. So, it is in the best interests of a seller to keep the wrap, rather than allow the buyer to assume the first mortgage.

There are relatively few wraparounds today because the first mortgage must be assumable, or the mortgagee must permit this type of assumption to occur on the loan. Today, only the FHA writes assumable loans, as most mortgage bankers have found that the main expenses (and profits) of a transaction occur at origination. Most mortgages have a due on sale clause to prevent the use of wraparounds.

What is an Option ARM?

An option ARM provides the option to pay as little as the equivalent of an amortized payment based on a 1% interest rate,(please note this is not the actual interest rate). As a result, the difference between the monthly payment and the interest on the loan is added to the loan principal; the loan at this point has negative amortization. In this respect, an option ARM provides a form of equity withdrawal (as in a cash-out refinancing) but over a period of time.

The option ARM gives a number of payment choices each month (for example, the equivalent of an amortized payment were the interest rate 1%, interest only based on actual interest rate, actual 30 year amortized payment, actual 15 year amortized payment). The interest rate may adjust every month in accordance with the index to which the loan is tied and the terms of the specific loan. These loans may be useful for people who have a lot of equity in their home and want to lower monthly costs; for investors, allowing them the flexibility to choose which payment to make every month; or for those with irregular incomes (such as those working on commission or for whom bonuses comprise a large portion of income).

One of the important features of this type of loan is that the minimum payments are often fixed for each year for an initial term of up to 5 years. The minimum payment may rise each year a little (payment size increases of 7.5% are common) but remain the same for another year. For example, a minimum payment for year 1 may be $1,000 per month each month all year long. In year 2 the minimum payment for each month is $1,075 each month. This is a gradual increase in the minimum payment. The interest rate may fluctuate each month, which means that the extent of any negative amortization cannot be predicted beyond worst-case scenario as dictated by the terms of the loan.

Option ARM mortgages have been criticized on the basis that some borrowers are not aware of the implications of negative amortization; that eventually option ARMs reset to higher payment levels (an event called "recast" to amortize the loan), and borrowers may not be capable of making the higher monthly payments; and that option ARMs have been used to qualify mortgages for individuals whose incomes cannot support payments higher than the minimum level.

Negative amortization loan

In finance, negative amortization, also known as NegAm, is an amortization method in which the borrower pays back less than the full amount of interest owed to the lender each month. The shorted amount is then added to the total amount owed to the lender. Such a practice would have to be agreed upon before shorting the payment so as to avoid default on payment. Also known as deferred interest or Graduated Payment Mortgage (GPM).

Defining characteristics of Neg Am

Negative amortization only occurs in loans in which the periodic payment does not cover the amount of interest due for that loan period. The result of this is that the loan balance (or principal) increases by the amount of the unpaid interest. The purpose of such a feature is to increase affordability, or add payment savings and payment flexibility to a loan.

Neg-Ams also have what is called a recast period and recast principal balance cap based on Federal and State legislation. The recast period is usually 60 months (5 years). The recast principal balance cap is usually up to a 125% increase of the amortized loan balance over the original loan amount. States and lenders can offer products with lesser recast periods and principal balance caps; but cannot issue loans that exceed their state and federal legislated requirements under penalty of law.

A newer loan option has been introduced which allows for a 40 year loan term. This makes the minimum payment even lower than a comparable 30 year term.

In economics, it is between a zero coupon and a straight coupon bond.

Typical Circumstances of Option Arm

All NegAM home loans eventually require full repayment of principal and interest according to the original term of the mortgage and note signed by the borrower. Most loans only allow NegAM to happen for no more than 5 years, and have terms to "Recast" (see below) the payment to a fully amortizing schedule if the borrower allows the principal balance to rise to a pre-specified amount.

This loan is written often in high cost areas, because the monthly mortgage payments will be lower than any other type of financing instrument.

Negative amortization loans can be high risk loans for inexperienced investors. These loans tend to be safer in a falling rate market and riskier in a rising rate market.

Start rates on negative amortization or minimum payment option loans can be as low as 1%. This is the payment rate, not the actual interest rate. The payment rate is used to calculate the minimum payment. Other minimum payment options include 1.95% or more.

Adjustable Rate Feature

NegAM loans today are mostly straight Adjustable Rate Mortgages (ARMs), meaning that they are fixed for a certain period and adjust every time that period has elapsed; e.g., one month fixed, adjusting every month. The NegAm loan, like all Adjustable Rate Mortgages, is tied to a specific financial index which is used to determine the interest rate based on the current index and the margin (the markup the lender charges).

Most NegAm loans today are tied to the Monthly Treasury Average, in keeping with the monthly adjustments of this loan. There are also Hybrid ARM loans in which there is a period of fixed payments for months or years, followed by an increased change cycle, such as six months fixed, then monthly adjustable.
The Graduated Payment Mortgage is a "fixed rate" NegAm loan, but since the payment increases over time, it has aspects of the ARM loan until amortizing payments are required.

The most notable differences between the Traditional Payment Option Arm and the Hybrid Payment Option Arm are in the start rate also known as the "minimum payment" rate. On a Traditional Payment Option Arm, the minimum payment is based on a principal and interest calculation of 1% - 2.5% on average.
The start rate on a Hybrid Payment Option Arm is higher, yet still extremely competitive payment wise.

On a Hybrid Payment Option Arm, the minimum payment is derived using the "interest only" calculation of the start rate. The start rate on the Hybrid Payment Option arm typically is calculated by taking the Fully Indexed Rate (Actual Note Rate), then subtracting 3%, which will give you the start rate.

Example:

8.5% fully indexed rate
(-) 3.0% Margin of the loan
= 4.5% start rate on a Hybrid Pay Option Arm)

This guideline can vary among lenders. Aliases the Payment Option Arm loans are known by:

• Negative Amortizing Loan (Neg Am)
• Pick - A - Pay
• Deferred Interest Option Loan

Criticisms of Negative Amortization loans

Negative Amortization loans, being relatively popular only in the last decade, have attracted a variety of criticisms:

• Unlike most other adjustable-rate loans, many negative amortization loans have been advertised with either teaser or artificially introductory interest rates or with the minimum loan payment expressed as a percentage of the loan amount. For example, a negative amortization loan is often advertised as featuring "1% interest", or by prominently displaying a 1% number without explaining the real interest rate. This practice has been done by large corporate lenders.
  
• This practice has been considered deceptive for two different reasons: most mortgages do not feature teaser rates, so consumers do not look out for them; and, many consumers aren't aware of the negative amortization side effect of only paying 1% of the loan amount per year. In addition, most negative amortization loans contain a clause saying that the payment may not increase more than 7.5% each year, except if the 5-year period is over or if the balance has grown by 15%. Critics say this clause is only there to deceive borrowers into thinking the payment could only jump a small amount, whereas in fact the other two conditions are more likely to occur.
  
• Negative amortization loans as a class have the highest potential for what is known as payment shock. Payment shock is when the required monthly payment jumps from one month to the next, potentially becoming unaffordable. To compare various mortgages' payment shock potential (note that the items here do not include escrow payments for insurance and taxes, which can cause changes in the payment amount):
  
  • 30-year (or 15-year) fixed-rate fully amortized mortgages: no possible payment jump.
    
  • 5-year adjustable-rate fully amortized mortgage: No payment jump for 5 years, then a possible payment decrease or increase based on the new interest rate.
    
  • 5-year adjustable-interest-only mortgage: no payment jump for 5 years, then a possible payment decrease or increase based on the new interest rate, combined with an increased payment due to the requirement to pay principal over a 25 year time frame.
    
  • Negative amortization mortgage: no payment jump either until 5 years OR the balance grows 15% higher than the original amount. The payment increases, by requiring a full interest plus principal payment. The payment could further increase due to interest rate changes. However, all things being equal, the fully amortized payment is almost triple the negative amortized payment.

NegAm - Mortgage Terminology

• Cap - percentage rate of change in the NegAm payment. Each year, the minimum payment due rises. Most minimum payments today rise at 7.5%. Considering that raising a rate 1% on a mortgage at 5% is a 20% increase, the NegAm can grow quickly in a rising market. Typically after the 5th year, the loan is recast to an adjustable loan due in 25 years. This is for a 30 year loan term. Newer payment option loans often offer a 40 year term with a higher underlying interest rate. Watch Out for this if you want to preserve your equity!
  
• Life Cap - the maximum interest rate allowed after recast according to the terms of the note. Generally most NegAm loans in the last 5 years have a life cap of 9.95%. Today many of these loans are capped at 12% or above! Watch out!
  
• Payment Options - There are typically 4 payment options:
  
  • Minimum Payment
  • Interest Only Payment
  • 30 Year Payment
  • 15 Year Payment
    
• Period - how often the NegAm payment changes. Typically, the minimum payment rises once every twelve months in these types of loans. Usually the rate of rise is 7.5%
  
• Recast - premature stop of NegAm. Should your negative balance reach a predetermined amount (up to 125% of the original balance per Federal or State regulations) your loan will be "recast" with one of two payment options: the fully amortized principal and interest payment, or if the maximum balance has been reached before the fifth year, an interest only payment until the loan has matured to the recast date. (typically 5 years)
  
• Stop - end of NegAm payment schedule.
  
  

What are Non-Conforming Mortgage

A non-conforming mortgage is a term in the United States for a residential mortgage that does not conform to the loan purchasing guidelines set by the Federal National Mortgage Association /Federal Home Loan Mortgage Corporation (Fannie Mae and Freddie Mac). Specifically, it has a dollar amount over the purchasing limit set by FNMA/FHLMC. These loans must remain in a lender's portfolio, or be sold to other companies who purchase larger loan amounts. Consequently, a premium is paid by those obtaining non-conforming mortgages, generally .25% or .5 points more than the same loan would cost if it were conforming. The loan amount is adjusted every few years depending upon the average sales price of homes in the U.S.

History of conforming loan limits

Standard or conforming mortgages

Many countries have a notion of standard or conforming mortgages that define a perceived acceptable level of risk, which may be formal or informal, and may be reinforced by laws, government intervention, or market practice. For example, a standard mortgage may be considered to be one with no more than 70-80% LTV and no more than one-third of gross income going to mortgage debt.

A standard or conforming mortgage is a key concept as it often defines whether or not the mortgage can be easily sold or securitized, or, if non-standard, may affect the price at which it may be sold. In the United States, a conforming mortgage is one which meets the established rules and procedures of the two major government-sponsored entities in the housing finance market (including some legal requirements). In contrast, lenders who decide to make nonconforming loans are exercising a higher risk tolerance and do so knowing that they face more challenge in reselling the loan. Many countries have similar concepts or agencies that define what are "standard" mortgages. Regulated lenders (such as banks) may be subject to limits or higher risk weightings for non-standard mortgages. For example, banks in Canada face restrictions on lending more than 75% of the property value; beyond this level, mortgage insurance is generally required (as of April 2007, there is a proposal to raise this limit to 80%).