How an Adjustable Rate Mortgage (ARM) works
The borrowers interest rate is determined initially by the cost of money and the time the loan is made. Once the rate has been set, and it is tied to one of several widely recognized and published indexes , and future interest adjustments are based on the upward an downward movements of the index. An index is a statistical report that is generally reliable indicator of the approximate change in the cost of money.
At the time a loan is made, the index preferred by the lender is selected, and thereafter the loan interest rate to rise and fall with the rates reported by the index. Since the index is a reflection of the lenders cost of money, it is necessary to add a margin to the index to ensure sufficient income for administrative expenses and profit. Margin will usually vary from 2% to 3%. The index plus the margin equals the adjustable interest rate. It is the index rate that fluctuates during the term of the loan and the cause of the borrowers interest rate to increase and decrease, the lenders margin remains constant.
Most lenders try to use an index to is very responsive to economic fluctuations. Some of the indexes are Treasury Rates--CMT-MTA-COFI-CODI-COSI-LIBOR-Prime Rate.
The margin is the difference between the index rate and the interest charged to the borrower.
9.25% - current index rate
2.00% - margin
11.25% - mortgage interest rate (note rate)
Rate adjustment period.
The rate adjustment period refers to the intervals and which a borrowers interest rate is adjusted, example: six months, one year, for years and so on. After referring to the rates movement in the selected index, the lender will notify the borrower of any rate increase or decrease. Annual rate adjustments are most common.
Lenders used two different mechanisms to limit the magnitude off payment changes that occur with interest rate adjustments: Interest rate caps and payment caps
An interest rate cap.
Lenders, consumers are concerned with a phenomenon called payment shock. Payment shock results from increase in the borrowers monthly payments which, depending upon the amount and frequency of payment increases, as well as the borrowers income, may eliminate the borrower's ability to continue making mortgage payments.
Payment Caps. This is a limit on the amount or percentage that a payment may change at each adjustment. If this cap was 7.50% and your monthly payment was $800.00, the most your payment could increase would be $60.00 - to $860.00. At the next adjustment, the most your payment could increase would be $64.50 (7.50% of $860.00 - for a $924.50 payment this period).
When lenders discovered residential adjustable-rate mortgage instrument in late 1979, recognize an opportunity to increase earnings. As public acceptance of adjustable-rate mortgages grew, so did the competition for adjustable-rate mortgage loans. To compete, lenders lowered the first-year interest rates on the loans they offered and introduce borrowers to discounts and buy-downs. The low initial rate have subsequently been dumped teaser rates. Many lenders offered attractive teaser rates merely to enlarge their portfolio of adjustable-rate mortgages. But since most adjustable-rate mortgages where he got interest rate caps prior to 1984, there are many instances where initial interest rates were increased by five to six percent. Clearly a crisis was developing.
To protect borrowers from payment shock and perfect lenders from portfolio shock, lenders began imposing caps on their adjustable-rate mortgages.
Fannie Mae and Freddie Mac caps.
Both Fannie Mae and Freddie Mac have guidelines relating to adjustable-rate mortgages interest rate caps. There are many different adjustable-rate mortgage plans, but as a general guideline, most adjustable-rate mortgages purchase by Fannie Mae are limited to the rate increase often no more than 2% per year and 5% over the life of the loan. Freddie Mac rate adjustment guidelines limiting rate increase to 2% per year and 5% over the life of the loan.
Mortgage payment adjustment period. The mortgage payment adjustment period defines the intervals and reach a borrower's actual principal and interest payments are charged.
There are two ways the rate and payment adjustments can be handled:
The lender can adjust the rate periodically as called for in the loan agreement and then adjust to mortgage payment to reflect the rate change. The lender can adjust the rate of more frequently than the mortgage payment is adjusted. For example, the loan agreement may call for interest rate adjustments every six months but changes in mortgage payments every three years.
If a borrower's principal and interest payment remains constant over a three-year period by the loans interest rate has steadily increased or decreased during that time, than to little or too much interest will have been paid in the interim. When this happens, the difference is subtracted from or added to the loan balance. When unpaid interest is added to loan balance, it is called negative amortization.
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