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HOW ARMS WORK Unlike the interest rate on a fixed rate loan, the interest rate you are charged on an ARM for the money you borrow changes or adjusts periodically based on changing economic conditions. Accordingly, your monthly payment may go up or down. Lenders usually charge lower initial interest rates for ARMs than for fixed rate loans because you are sharing the risk if interest rates go up. ARMs, therefore, are less expensive - especially in the beginning - than fixed rate loans. This may mean that you can qualify for a larger loan if you select an ARM. However, there is also the risk that a loan could become burdensome in the event interest rates increase substantially in the future. Index ARM interest rate changes are tied to changes in an index rate. An index rate usually goes up or down with the general movement of interest rates. If interest rates move up, so will your ARM interest rate and, in most circumstances, so will your monthly payment. Likewise, if interest rates go down, your monthly payment may go down. There are a number of indexes used for ARMs. Each one has distinct market characteristics and fluctuates differently. We have selected three popular ARMs for demostration purposes.
Recent Index Comparison No one can be sure when an index rate will go up or down. To help you compare different indexes, the following chart shows a comparison of four indexes from 1985 through 1994. As you can see, some index rates tend to be higher than others, and some fluctuate more rapidly. You should ask how the index for any ARM you are considering has changed in recent years, and where it is reported.
Margin To establish your ARM interest rate, percentage points are added to the index rate you choose. These percentage points are called the margin. The margin is established by the lender and stays the same for the term of the loan. Your ARM interest rate will be adjusted periodically. Your ARM interest rate is fully indexed when it equals the index plus the margin.
The size of the margin is an important consideration when comparing ARM loan options. Here is an example of how two identical ARM loans with different margins can make a very real difference to you.
Why ARM Interest Rates Are Lower Than Fixed Rates Remember, interest rates are usually lower for ARM loans initially than for fixed rate loans of the same amount. With a fixed rate loan, you are paying for the security of knowing that your interest rate (and your monthly loan payment) won't change in the future. When shopping for a home loan, you should compare the fully indexed ARM rates with available fixed rates. Initial Interest Rates on ARMs Are Sometimes Different than the Fully Indexed Rate If the initial interest rate is lower than the index plus the margin, it is called a discounted rate. If the initial interest rate is higher than the index plus the margin, it is called a premium rate. The size of the discount or premium is the difference between the initial interest rate and the index rate plus the margin. Although some lenders use the lower initial interest rate to approve your loan in the case of a discount, you should consider your ability to afford payments after the discount period ends. Depending on the amount of the discount, you may be charged additional points. And, after an initial ("introductory'') period, the ARM rate may increase significantly. The initial period is usually not very long, and higher payments later on may make up for this initial discount. Sometimes, the seller pays a fee to the lender or into escrow in order to give you lower loan payments during the initial discount period. This is referred to as a seller buydown. However, you remain liable for the entire amount of the payment in the event the seller's share becomes unavailable for any reason. Keep in mind, the seller may increase the purchase price to cover the fee to the lender for the buydown. In such a case, you will be covering this cost as part of the cost of the home. Interest Rate Caps All ARM loans being made today have an upper limit on how high your interest rate can go. In addition, many ARMs have limits on periodic interest rate adjustments to protect borrowers from the effect of dramatic interest rate fluctuations The Adjustment Date The interest rate and your monthly loan payments can go up or down on a periodic basis. The date on which an interest rate change occurs is called the interest rate adjustment date. The date on which a payment change occurs is called a payment adjustment date. Your monthly payment may change at the same time the interest rate changes, but on some ARMs payment changes may occur less frequently. When comparing ARMs, ask how often the interest rate and payment may change. Maximum Periodic Adjustments Some of our ARMs have an interest rate adjustment cap limiting how much your interest rate or payment can change on each adjustment date. Payment Shock Payment shock may occur if your home loan payments are not protected by an interest rate adjustment cap. For example, if your ARM interest rate were to adjust upward by four percentage points on any given adjustment date, your monthly payment could increase by as much as 53% in a six-month period. That's payment shock!
In the next example, notice how the payment shock is reduced with an interest rate adjustment cap, because it would take two years to reach the same higher payment.
Other Payment Increases A drop in interest rates does not always lead to a drop in monthly payments. In fact, with some ARMs, your payment amount may increase even though the index rate has stayed the same. If the fully indexed rate is higher than your current rate, your interest rate can go up even if the index is declining or remains constant. This may happen after an interest rate adjustment cap has been holding your interest rate down below the sum of the index plus margin. It may also happen if a payment is below the fully amortizing amount. In the example below, there was an interest rate adjustment cap of two percentage points and the index went up three percentage points at the first adjustment. Assume the index stays the same through the third year. Your rate, which started at 6%, would go up to 9%.
Calculation of the Adjustment Within the proscribed limits, your ARM interest rate is adjusted on each adjustment date based on changes in the index.
Maximum Interest Rate Ceiling ARM payments can continue to rise if general interest rates rise. As further protection to you, ARM home loans have a maximum interest rate ceiling. This means that no matter how high the general interest rates or the index may go, your interest rate will never exceed a certain percentage rate. Your loan representative can give you the maximum interest rate ceiling for each loan we offer. New Payment Amount For ARM loans, your lender will notify you in writing at least 25 days before each change in your monthly payment. Your notice will include information about the index rate, your new interest rate, revised payment amount, and the outstanding loan balance used to calculate the new payment. Payment Cap Some ARMs offer caps on the amount your payment can change on any given adjustment date. In other words, with a 7.5% payment cap, a payment of $100 could increase to no more than $107.50 at the next payment adjustment date. This limit on monthly payment increases could lead to deferred interest. Deferred Interest If an ARM loan has a payment cap, and the index rate rises, your monthly payment could cover only part of the increased interest. The amount of interest not covered by your monthly payment (the deferred interest) would be added to your loan balance (principal) each month. The result is that the amount you owe on your principal can increase instead of decrease. This is sometimes called negative amortization.
Prepayment In some instances, should your financial circumstances change, you may decide to prepay (or pay off) your loan early. Some lenders require a fee for paying off the loan early, while other lenders do not. Some of our loan programs may have a prepayment fee. Be sure to ask about prepayment fees. The amount and any restrictions will be spelled out in your loan documents.
Converting an ARM to a Fixed Rate Loan Some ARM loans offer you a conversion option to a fixed rate loan. If you believe that interest rates are going to fall in the future, you may wish to have a loan with the conversion option. Let's say your maximum interest rate ceiling is 13%. Let's also assume that interest rates decrease and you find that you can convert to a fixed rate loan of 10%. In this case, you could "lock in" payments at 10% for the remainder of your loan term by converting. If you converted, you would never have to worry about higher interest rates affecting your loan payment. Please note, however, if you convert to a fixed rate loan, the loan will no longer be assumable. Convertible Option Our convertible loans offer this option beginning with the second year of the loan (which begins on the 12th payment due date), and conversion can be made any time before the end of the fifth year of the loan (which ends on the 60th payment due date). Calculating Your New Fixed Rate Loan The new interest rate will be based on the Federal National Mortgage Association (FNMA) required net yield in effect for specific commitments to purchase fixed rate home loans at the time you wish to convert plus a spread. This rate may be higher or lower than the rate we are offering for new fixed rate loans at the time you convert. If you convert to a fixed rate loan, your outstanding loan balance will be amortized in substantially equal payments over the remaining term of your loan. Your interest rate and payments will stay the same until the loan is paid off. Cost to Convert If you select a convertible ARM, the loan origination fee or initial interest rate may be higher than for other ARM loans. If and when you exercise your conversion option, you may also be required to pay additional fees in order to convert to a fixed rate loan. You must also meet certain conditions to be eligible to convert your loan to a fixed rate. We can give you more information about convertible loans. |
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