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Kevin J. Daum
This article was originally published in the September
2004 edition of Log Homes Illustrated magazine.
Whether you own a log home or a stick built home, there is
no shortage of choice in today’s market for mortgages.
In the old days it was easy: You could have a 30-year fixed
or a 15-year fixed. Now it’s almost as bad as ordering
at a Starbucks. “Would you like a short term fixed or
a 3/1 arm, perhaps some negative amortization to go with that?
Maybe a coffee arm would do for you or even a LIBOR, no-neg,
monthly float with a life cap, low margin and a side of fries?
Thanks for ordering at Loans-R-Us!”
How is a human being with a reasonable intelligence supposed
to navigate through all this banker gobbledy-gook? The banks
offer adjustable-rate mortgages (ARMs) because they help share
the risk of interest rate increases and can provide lower
payment options to you, the consumer. But these loans are
designed by Harvard MBAs for Investment Bankers on Wall Street.
Sadly most Loan Officers do not really understand how they
work.
OK, here it is! The much requested, long awaited Adjustable
Rate Mortgage Primer! I can’t promise to make you all
experts on ARMs in a single column, but this will serve as
a reference sheet to have meaningful conversations with your
Loan Officer. Let’s start by learning some standard
ARM terms. Almost all ARMs are based upon a 30-year term and
have the same basic components. First we will define the easy
ones:
Start Rate – This is the initial interest
rate of the loan. This is often called a Teaser Rate because
the banks like to give you a low rate at the beginning, which
they know to be below the current market.
Life cap – This is the highest rate
that the loan can go to over its lifetime. Sometimes the bank
will give you an exact number like 9.95%. Other times they
will base it on the Start Rate plus a number like 6%. So if
your Start Rate were 4% your Life Cap would be 10%.
Index – This is the published number
your loan is tied to. Somehow they have to determine whether
your rate will move up or down, so they connect it to a published
rate. Most are tied to some sort of short-term lending rate.
Some common examples: Prime - the rate that the banks use
to lend commercial money to big corporations; London Inter-Bank
Offered Rate (LIBOR) - essentially European Prime; 11th District
Cost of Funds Index (COFI) – the least volatile of all
the ARM indices because it goes up the slowest but it goes
down the slowest as well; 1-Year Treasury Index – the
most common index, tied to the T-Bills sold by the U.S. government.
There are others as well. Believe me, if someone publishes
an index, some bank will create a loan around it. You can
watch the movement and look at the history of any of these
indices on the Internet by using Yahoo or Google.
Margin – The banks have to figure
in some margin of profit, so when they tie your loan to an
index they add a certain percentage to make the rate attractive
to their investors. Otherwise, the investors could invest
in the index itself. With the exception of Prime, which has
a lower margin, most of the indices have a margin ranging
between 2 and 3 percent.
Fully Indexed Rate – Also called the
Float Rate, this is the actual interest rate when you add
your margin plus your index. For example, if your loan is
based upon LIBOR plus a 2.5% margin and LIBOR today is at
1.5%, then your Fully Indexed Rate or Float Rate would be
2.5 + 1.5 or 4 percent.
These next terms are a little more interesting.
Rate Adjustment Period - This term reflects
how often your rate moves. Sometimes it can move every month,
or it might have a slower period of adjustment, like six months
or a year.
Rate Adjustment Cap – Just because
it moves doesn’t mean it has no boundaries. This cap
will protect you when the Float Rate makes a big jump up or
block you if the Float Rate makes a big drop. Generally most
ARMs have a periodic cap of 1 percent per 6 months or 2 percent
per year if there is a cap at all.
Payment Adjustment Period – Depending
upon the type of ARM, your payment may move with the Rate
Adjustment or it may not. If it doesn’t move with the
Float Rate, then it likely will adjust every year on the anniversary
of the loan. Unlike husbands, banks rarely forget your anniversary.
Payment Adjustment Cap – Believe it
or not, the bank cares whether your payment increase might
be uncomfortable for you, so they allow for a payment cap.
This cap is usually 7.5 percent of the payment amount. So
if your payment is $1,000 now, the most it can go up at the
anniversary would be $75 if you have this cap. If your payment
still isn’t enough to cover the interest then the bank
will let you tack on the difference to the balance of your
mortgage. This is what those brilliant bank marketers refer
to as Negative Amortization. Amortization is how a loan is
paid off in equal installments over a period of time. Negative
Amortization is when your loan balance increases.
OK, now that you know all the terms, let’s see how
they all go together. We will look at a typical ARM without
Negative Amortization. It has a start rate of 2.25 percent
and is tied to the 1-year treasury index, which is roughly
1.5 percent today plus a 2.5 percent Margin. The loan moves
once a year and has a 2 percent adjustment cap and a 6 percent
life cap meaning it can move up or down no more than 2 percent
at each adjustment and the highest it can ever move is 8.25
percent.
Your payment will be amortized based upon 2.5 percent for
one year and then it will move to the float rate or the start
rate plus the margin whichever is lower. In other words if
the rates are the same in one year your rate will go to 4%
and your payment will adjust accordingly to make sure you
are still paying down your loan over 30 years. This loan can
benefit you with a low interest rate but there are better
low payment options today.
Neg-Am
The Negative Amortization loan is often referred to as providing
the greatest flexibility. This loan like the one before will
have a low Start Rate. The Rate Adjustment Period on this
loan, however, is monthly with no Rate Adjustment Cap other
than the Life Cap. That means your Float Rate could move significantly.
The good news is that your minimum payment will be based upon
your Start Rate and only move once a year with a Payment Cap
of 7.5 percent as discussed above.
Every month you will have a choice. You can pay the minimum
payment, and if it does not cover the interest, then your
loan will get bigger. This sounds bad, but chances are that
your house appreciated more than you saved last year, so why
not let it make some of the payment for you. You also have
the option of making more than your minimum payment. You can
pay just the interest or pay off some or all of the balance
in any given month. This loan does give you total flexibility
to choose your own payment each and every month. This works
well in a downward or relatively stable interest rate environment,
which we have been in for the last 25 years.
Short Term Fixed
These loans are also generally referred to as 3/1 or 5/1 ARMs.
Simply put, they are fixed for three or five years and then
turn into No Negative Amortization ARMs after the fixed period.
If you do not have the stomach for a changing interest rate,
then these could be the loans for you. They can often be as
much as 1 percent cheaper in rate than a fully amortized 30-year
fixed rate loan, saving you a significant amount in interest.
The thousands of dollars
you save over the fixed rate can
more than make up for a refinance.
Usually when you choose a short-term loan, you are planning
on some financial change within five years. You might plan
to sell or perhaps you are expecting a promotion or an inheritance.
In any case, the risk you might be taking is that of the prevailing
market rates when the loan goes past its fixed period. Of
course, the thousands of dollars you save over the fixed rate
can more than make up for a refinance down the line. Most
people refinance every 3 to 5 years anyway to either take
cash or restructure other debts.
Interest-Only
Because I haven’t thrown enough confusion your way I
am now going to highlight the newest trend in mortgages, the
Interest Only Option. The banks recently figured out that
most of you only keep your loans for a short time and that
you pay off relatively little principal. They concluded that
offering you the chance to only pay interest gives you a lower
payment but has no bad news for them on how much money they
make. Ultimately when you pay off the loan they get all there
money back anyway. This option is now offered on most ARMs,
especially on the 3/1 and 5/1 ARMs.
This is excellent news for you because putting several hundred
extra dollars every month into your house will not benefit
you when you go to sell. This way you can have the money to
make your life a little better or invest it in other diversified
investments.
You have to consider which makes more sense for you –
tying up your money in your home (as equity) or saving a few
hundred dollars each month. That money could have a significant
impact on your cash flow. One note: if you are someone with
no ability to save under any circumstances, consider this
in your decision. As much as I favor cash over equity, money
is better saved in the house then squandered away.
Let’s wrap it all up. ARMs are scary because they are
confusing, and it is hard to understand every detail. The
biggest fear about ARMs is that the rates will go up and you
will be stuck paying on a high interest loan. Here are the
facts. Nothing says that the rates couldn’t skyrocket
again, but the last time we saw screaming interest rates was
almost 25 years ago and many new protections in our economy
have taken place since then. The largest increase that short-term
mortgage rates have had in the last 20 years is 1.5 percent
over an 18-month period in 1993 and 1994. If you had an ARM
then, you wouldn’t have even hit your Adjustment Caps.
Do your homework. Find a recommended loan officer who deserves
your trust and will answer your questions about ARMs. Put
your emotions aside and base your decision on a real assessment
of the time you intend to have this loan. This way you can
pick an ARM with real legs.
Kevin Daum is the Founder and CEO of Stratford Financial
Services, a Real Estate finance and education company, founded
in 1989. Stratford specializes in Purchase loans, Refinance
loans and Custom Home Construction finance and has successfully
financed thousands of clients. He is the author of "Building
Your Own Home for Dummies" (Wiley), as well as "What
the Banks Won’t Tell You." Mr. Daum was an Underwriter
for Plaza Savings and Loan and Key Bank of New York. He is
an INC 500 CEO and has been listed as one the 40 Most Influential
People Under 40 in the San Francisco Bay Area. He is the Global
Chair for the Edison Innovation Program with the Young Entrepreneurs'
Organization (YEO) and is a founding Board member of the Bay
Area Chapter of YEO.
Mr. Daum is a frequent contributor to numerous business
publications on the subjects of Real Estate and Small Business
leadership and speaks regularly on both subjects. He can be
contacted at kevin@stratfordfinancial.com.
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