Reach Out and Take This ARM! Financing with an Adjustable Rate Mortgage

Transcription

1 Reach Out and Take This ARM! Financing with an Adjustable Rate Mortgage by Natalie Danielson A Washington State Approved Real Estate School under R.C.W

2 Reach Out and Take This ARM! Financing with an Adjustable Rate Mortgage Curriculum Session Hours Major Topics Method of Instruction 1 1/2 hour Learn about the ARM loan programs Take a look at the advantages and the considerations of the borrowers. Lecture Discussion 2 2 hours Understand the variables and features including the different indexes, caps, margins, rates. Learn the questions to ask about ARM's Lecture Discussion 3 1/2 hour Discover the disclosures required Learn to analyze different ARM programs Lecture Discussion PROFESSIONAL Direction, Inc. (Revised June 1999, 2002, 2003, 2008, 2009, 2011, Aug 2013, Aug 2015) 2

3 Reach Out and Take This ARM! Financing with an Adjustable Rate Mortgage The interest rate has fluctuated so dramatically over the past two decades. Predicting what it will do next is left up to those who are in the business of being surprised. In the early 1980's the prime rate hit just over 18%. Before that rates were down to 7.5% and only a few years later they were back to 7.5%. The spring of 1994 rewarded home purchasers and those refinancing with rates lower than we have seen in 20 years. In the last decade rates have stayed at 5% or less. As the rates start to inch upward, panic often sets in. Lenders are in the business of packaging money for home buyers and their packages reflect the economy. As rates inch upward, lenders are back to offering aggressively Adjustable Rate Mortgages (ARM's). When the borrower has an ARM loan, the risk of fluctuating interest rates is absorbed by the borrower as well as the banks. They are a solution to the uncertainty of future interest rate fluctuations. Course Objectives As a result of taking this course the real estate agent shall be able to: Identify the advantages and disadvantages of an adjustable rate mortgage. List the different elements of an ARM loan. Know the differences between the different indexes used for ARM loans. Know the effect of caps and adjustment periods on ARM loans. Compare different ARM loan programs. Realize that the lender is required to provide disclosures and the Annual Percentage Rate. PROFESSIONAL Direction, Inc. (Revised June 1999, 2002, 2003, 2008, 2009, 2011, Aug 2013, Aug 2015) 3

4 What is an Adjustable Rate Mortgage? An Adjustable Rate Mortgage (ARM) is a loan where the parties agree to float mortgage rates based on the fluctuations of a monetary index. The interest rate changes periodically based on the changes in the interest rate in a chosen index. The index is the cost of money to the lender. The ARM passes some of the risk of fluctuating interest rates on to the borrower. Advantages of ARM loans An ARM could prove to be less expensive than a fixed rate loan to a borrower. The initial rate if often lower and sometimes referred to as a start or teaser rate. Over the long run an ARM could prove to be considerably less expensive than a fixed-rate mortgage if interest rates remain steady or move lower. In addition, the borrower can often pay off a part of the principal and lower their payment at the next adjustment period. If they do that on a fixed loan the term of the loan would shorten but the payment would remain the same. What questions should borrowers consider prior to choosing an ARM loan? Is my income likely to rise enough to cover higher mortgage payments if interest rates increase and my payment goes up? Will I be taking on other sizable debts, such as a loan for a car or school tuition? How long do I plan to own this home? PROFESSIONAL Direction, Inc. (Revised June 1999, 2002, 2003, 2008, 2009, 2011, Aug 2013, Aug 2015) 4

5 Elements of an ARM Loan Interest Rate Often with ARM's the lender offers a start or "teaser" rate to the borrower for the first adjustment period. This rate is not necessarily tied to the index or the margin. It is a lower rate than the loan would actually be so that the borrower can more easily qualify. This lower rate is usually in effect for a short period of time and then the rate and payment can change. The start rate is different than the actual interest rate for the loan. It is important to compare loans using the Annual Percentage rate (APR). if the APR is significantly higher than the initial rate, then it is likely that the rate and payments will be a lot higher when the loan adjusts, even if the general interest rates remain the same. Questions to ask about start rate: What is the initial start or teaser rate? What is the actual note rate? How much of the teaser has been discounted? What is the term of the teaser rate? What will the monthly payment be at the first adjustment? Is it an interest only loan? PROFESSIONAL Direction, Inc. (Revised June 1999, 2002, 2003, 2008, 2009, 2011, Aug 2013, Aug 2015) 5

6 Index The interest rate on an ARM is made of up two parts: The index rate and the margin. The index is a measure of interest rates generally, and the margin is an extra amount that the lender adds. Your payments will be affected by any caps or limitson how high or low your rate can go. Lenders tie the ARM interest rate to changes in an "index rate." It is an index that reflects the cost of money. The indexes usually go up and down with the general movement of interest rates. There are a variety of indexes that ARM rates are based upon. Lenders choose the indexes as a part of the loan program. The type of index does not change during the life of the loan. Some indexes are more volatile than others. But, they all generally follow a pattern. So it is important to ask how much they fluctuate historically. One year Treasury Bill or CMA (Constant Maturity Average) This was the first and the most common index for ARM's. It is the monthly average of the weekly auction on the Treasury bills. Eleventh District Cost of Funds (COFI) This is also known as the FHLB 11 District. It is the average of the interest rates savings and loans pay for deposits and other borrowings with a certain range of maturities in the Federal Home Loan Bank s 11 th District. The 11 th District is comprised of member banks in California, Arizona and Nevada. Even if market rates are rising or falling rapidly, it may be some time before enough savings accounts and other borrowings mature and affect the index. It is a more stable index than the treasury bills. The London Interbank Offering Rate (LIBOR) Also known as the LIBOR, this is one of the newer indexes in use for ARM's. It follows the London interest rate. It is an international index based on the rate commercial banks pay for short-term loans from other commercial banks on the London Market. It follows the money market but does not react with the high's and lows that the one year Treasury Bills do. It is a common international interest rate index. Monthly Treasury Average (MTA) The 12 month treasury average index is based on average monthly yields on U.S. Treasury Securities adjusted to a constant maturity of one year, as made available by the Federal Reserve. The index is determined by addiing together the monthly yields for the most recent 12 months and dividing by 12. Other Indexes There are other indexes such as the CD's and Prime Rate. PROFESSIONAL Direction, Inc. (Revised June 1999, 2002, 2003, 2008, 2009, 2011, Aug 2013, Aug 2015) 6

7 The Index is one of the most important factors in the Adjustable Rate Mortgage. It is important to understand what index the lender is using and how quickly it reacts to the market and interest rates change. Questions to ask about Indexes What index is being used for the ARM you are considering? Does it accurately reflect the lender's costs of funds? How quickly does it react to changes in the market? What is it's history? How did it react between ? Will the lag time for increases and decreases in the market be the same? Which movement would show up first, and increase or decrease? What will the interest rate be if the index does not change by the first adjustment? PROFESSIONAL Direction, Inc. (Revised June 1999, 2002, 2003, 2008, 2009, 2011, Aug 2013, Aug 2015) 7

8 Margin The margin on the ARM is as significant as the index. The margin is the spread between the index rate and the interest rate the borrower is charged. This is the percent that the lender makes on the loan. Whatever the index rate is, the lender adds the margin and passes the new rate on to the borrower. It is usually constant over the life of the loan. The fully indexed rate is equal to the margin plus the index. Index Rate + Margin = ARM Interest Rate Questions to ask about margins. What is the amount of the margin? What would the interest rate be if the index does not change by the first adjustment? Can the margin be discounted or bought down? What is the highest rate that the lender will charge the borrower? PROFESSIONAL Direction, Inc. (Revised June 1999, 2002, 2003, 2008, 2009, 2011, Aug 2013, Aug 2015) 8

9 Adjustment Period The period between one interest rate change and the next is called the rate adjustment period. The period between payment changes is called the payment adjustment period. Rate Adjustment Period The borrowers interest rate is not adjusted every time the index changes. The rate adjustment period is the interval at which a borrower's interest rate is adjusted. The adjustments may be made every six months, once a year, every three years or every 10 years. A rate adjustment period of one year is the most common, and ARMS with one year rate adjustment periods are referred to as "One-year ARMS." Payment Adjustment Period The borrowers actual payment will change at a given interval. That interval does not always coincide with the interest rate adjustment period. There are two ways the rate and payment adjustments are handled 1. The lender can adjust the rate periodically as called for in the loan agreement and then adjust the mortgage payment to reflect the rate change. An example is a one year ARM that the rate and payment adjust each year. 2. The lender can adjust the rate more frequently than the mortgage payment. An example is an ARM with interest rate adjustment every six months but changes in mortgage payments every three years. PROFESSIONAL Direction, Inc. (Revised June 1999, 2002, 2003, 2008, 2009, 2011, Aug 2013, Aug 2015) 9

10 Caps In the past there were virtually no real caps placed on the interest rate on ARM loans. Today, there are a number of different caps. They are designed to protect the borrower and the lender so that the borrower knows the "worst case scenario" if the index rises to a very high rate. When the interest rate and therefore the payment rises the borrower can find themselves in "payment shock." Periodic Caps A cap can be placed on the interest rate for each period. An example would be a 1% cap on the interest over a 6 month period. The lender could not charge the borrower more than 1% more regardless of whether the interest rate rose 2% during that period. Lifetime Caps A cap can be placed on he interest rate for the life of the loan. An example would be a 6% cap on the interest rate the borrower would be charged for the entire life of the loan regardless of what the index does. The lender could not raise the interest rate more than 6% during the live of the loan even if the interest rate on the index rose 7%. Payment Caps A cap can be placed on the payment so that the payment does not go higher than a given amount regardless of the interest rate. On many ARM loans the payment cannot go up higher than 7.5% which is about equivalent to raising the interest rate on the loan 1%. If there is a payment cap, that doesn t mean that the borrower isn t charged the higher interest. If the payment is capped but the interest rate is higher than the payment cap, the resulting unpaid interest is added to the principal of the loan resulting in deferred intererst or negative amoritization. Often lenders give borrowers several payment options each month. They can pay the minimum the lender will require, make the minimum plus any interest that may be deferred, or pay the payment, the interest, and an additional amount pay off some of the principal. PROFESSIONAL Direction, Inc. (Revised June 1999, 2002, 2003, 2008, 2009, 2011, Aug 2013, Aug 2015) 10

11 Questions to ask about caps Does the loan provide reasonable caps to prevent payment shock? Are there caps on the discounted rate, note rate, or both? Could any of the caps cause negative amortization or deferred interest? Is there a lifetime cap on the interest rate? Do both annual and lifetime caps apply to decreases as well as increases? Is there a minimum rate? Are the caps based upon a teaser or start rate or are they based on the note rate? Can increases in the index beyond the rate be carried over to subsequent years? PROFESSIONAL Direction, Inc. (Revised June 1999, 2002, 2003, 2008, 2009, 2011, Aug 2013, Aug 2015) 11

12 Payment Shock Payment shock may occur if the mortgage payment rises sharply at a rate adjustment. Here is an example from the Consumer Handbook on Adjustable Rate Mortgages: Let s assume that the lender s fully indexed 1-year ARM rate (index rate plus margin) is currently 6%; the monthly payment for the first year would be $1, But your lender is offering an ARM with a discounted initial rate of 4% for the fi rst year. With the 4% rate, your first-year s monthly payment would be $ With a discounted ARM, your initial payment will probably remain at $ for only a limited time and any savings during the discount period may be offset by higher payments over the remaining life of the mortgage. If you are considering a discount ARM, be sure to compare future payments with those for a fully indexed ARM. In fact, if you buy a home or refinance using a deeply discounted initial rate, you run the risk of payment shock, negative amortization, or prepayment penalties or conversion fees. Let s see what would happen in the second year if the rate on your discounted 4% ARM were to rise to the 6% fully indexed rate. As the example shows, even if the index rate were to stay the same, your monthly payment would go up from $ to $1, in the second year. Suppose that the index rate increases 1% in 1 year and the ARM rate rises to 7%. Your payment in the second year would be $1, That s an increase of $ in your monthly payment. You can see what might happen if you choose an ARM because of a low initial rate without considering whether you will be able to afford future payments. If you have an interest-only ARM, payment shock can also occur when the interest-only period ends. Or, if you have a payment-option ARM, payment shock can happen when the loan is recast. PROFESSIONAL Direction, Inc. (Revised June 1999, 2002, 2003, 2008, 2009, 2011, Aug 2013, Aug 2015) 12

13 Negative Amortization Negative amoritization is also known as deferred interest. When the borrower makes a payment on the ARM and the rate or the payment has reached the cap, there may be some unpaid interest. This unpaid interest is added to the principal is called negative amortization. Some lenders give the borrower the choice at each payment to pay the full amount or pay the minimum and have some negative amoritization. When adjustable rate mortgages were used often in the 1980 s when the interest rate was so high. Many lenders created ARMS whereby the payment didn t change as often as the interest. Many borrowers, when the were ready to sell the home found they didn t have the equity that they had thought. The negative amoritization or deferred interest was added to the principal of the loan amount resulting in a higher loan and lower equity. Deferred interest can quietly eat away at the equity in the home if a borrower is not watchful. Questions to ask Is there negative amortization on this ARM? (This is one of the most important questions) Is the negative amortization limited? If the maximum allowable negative amortization is reached, how will it affect the original terms of the loan? What are my options to avoid negative amortization? PROFESSIONAL Direction, Inc. (Revised June 1999, 2002, 2003, 2008, 2009, 2011, Aug 2013, Aug 2015) 13

14 Conversion Options Often ARM loans have a conversion option whereby the borrower can choose to convert the ARM to a fixed rate loan for the remaining life of the loan. Usually the conversion option can only be exercised at a certain time period and there is a limited time period during the loan term to convert. There can be a requirement that the property be reappraised at the time of conversion. The lender often charges a conversion fee. The rates are not the going street rate. Questions to ask about conversion options When can the conversion be made? Anniversary date? Anytime after a certain date? How long is the option available? At what rate will the conversion be made? At best, available current fixed rate or will the rate be increased? Is there a fee involved to convert? Does the buyer have to pay costs like credit report, title report, etc.? Does the borrower have to qualify again at the time of conversion? What determines the rate the borrower will convert to? What are the advantages and disadvantages of conversion? PROFESSIONAL Direction, Inc. (Revised June 1999, 2002, 2003, 2008, 2009, 2011, Aug 2013, Aug 2015) 14

15 ARM Disclosures The Truth in Lending Act and Regulation Z require lenders to make certain disclosures to ARM borrowers. They are required to provide the borrower with a general brochure on ARM's. There is a consumer handbook on ARMS published by the Federal Reserve Board that satisfies this requirement. In addition, the lender must make specific disclosure for the particular loan program that the borrower chooses. These include the following: The index The rate and payment Adjustments Discounted interest rate, if applicable Caps Conversion Negative Amortization, if applicable Adjustment Notices Prepayment penalty, if any Acceleration Clause The lender must give the borrower an historical example illustrating how the payments on a $10,000 loan would have been affected by the rate changes over the past 15 years and an example of how the rate and payment would be calculated on a $10,000 loan. The Adjustable Rate Mortgage disclosure statement details feature common to all types of loan programs. It does not specify the interest rate, margin, index or other features of the loan. The note that the borrower signs will detail all the information on that particular loan. The lender also must provide the borrower with the Annual Percentage Rate. PROFESSIONAL Direction, Inc. (Revised June 1999, 2002, 2003, 2008, 2009, 2011, Aug 2013, Aug 2015) 15

16 What are reasons some ARM loans are in default? When the real estate market was seeing quite a surge in sales after the turn of the century, many of the loans were ARM loans. There were a good percentage that were interest only. So with low rates and no principle, the payments were low. Often loans had balloon payments which would require a borrower to refinance in 3-5 years. They also had prepayment penalties that would make it almost impossible to sell the house in a short time after purchase. Questions to ask about defaulting ARM loans Why do you think many h omeowners defaulted on ARM loans? How do you see mortgage rates when you pull out your magic wand? Do you see ARM loans becoming more prevalent or less in the future? Appendix Copy of an Adjustable Rate Mortgage Loan Disclosure Statement Comparison Chart of different Indexes used for ARMS Get the Adjustable Rate handbook PROFESSIONAL Direction, Inc. (Revised June 1999, 2002, 2003, 2008, 2009, 2011, Aug 2013, Aug 2015) 16