An adjustable-rate mortgage is characterized by fluctuating rates depending on certain factors. The interest rate is applied to the outstanding balances throughout the life of the loan. The interest rate is initially fixed for a time period, after which it is reset periodically or specific intervals (monthly or yearly). The calculation of the interest rate is based on a benchmark or financial index (any of the Libor rate, Feds Fund rate or One-year Treasury bill), plus an additional spread referred to as ARM margin. As the underlying financial index changes, the lender may also revise the loan’s interest rate. It is also called a variable-rate mortgage or floating mortgage. They are expressed in two numbers; one signifying the length of time the interest is fixed while the other number indicates the period when interest rate can fluctuate.
The major advantage of adjustable-rate income is that it offers a lower rate than fixed-rate mortgages. Since some rates are tied to the 10-year Treasury note, it offers borrowers the opportunity to buy bigger houses for less and is very attractive for individuals with moderate incomes.
The disadvantage of this mortgage option is that the monthly payment may skyrocket in the event of an increase in interest rates. When interest rates are reset, individuals whose incomes are fixed may find themselves in tight positions to repay. This may eventually lead to losing the home or not being able to afford it. However, there are rate caps that determine the limit to the periodic rate changes.
A hybrid ARM is also known as a fixed period ARM which is characterized by a blend of a fixed-rate mortgage and an adjustable-rate mortgage plan. Hybrid ARM Mortgages carry an initial fixed interest rate period that is followed by an adjustable-rate period. This means when the fixed-rate period expires, it sets off the change to an adjustable rate which is calculated based on an index plus the margin. The date at which the interest rate changes from a fixed rate to an adjustable rate is referred to as the reset date.
The most common hybrid Arm configuration is the 5/1 which indicates an initial fixed interest rate of 5 years followed by an adjustable interest rate that is reset every twelve months. Other hybrid ARM configurations such as 3/1, 7/1 and 10/1 offer introductory fixed interest rates for 3 years, 7 years and 10 years respectively after which they are subjected to adjustable interest rates that are reset once annually. Some other hybrid configurations give room for adjustable rates that are not subjected to annual changes. For instance, a 5/5 hybrid ARM is configured to give room for fixed-rate interest for the first five years followed by another adjustable-rate that is reset just once in five years. In any of the configurations, the calculation of the adjustable-rate can include a look back period; a prior period whose index the lender refers to at the reset date.
An FHA loan is a mortgage that is not only issued by an FHA-approved lender but also insured by the Federal Housing Authority (FHA). It is a loan scheme designed for low and moderate-income earners, requiring a lower minimum down payment as well as good credit scores in relation to other conventional mortgages. The down payment is as low as 3.5% while a credit score of 580 or higher is enough to prequalify. However, for individuals whose credit score is below 580, they can still access FHA loans provided they can provide 10% down payment. FHA loans require that borrower should pay two kinds of mortgage premiums; an Upfront Mortgage Insurance Premium (UFMIP) as well as Annual Mortgage Insurance Premium (Annual MIP) which is charged monthly. By paying the insurance premiums to the FHA, any default in payment by the borrower is taken up by the FHA.
Qualifying for FHA loan is quite easier than qualifying for a conventional loan since the latter is not insures or guaranteed by the government. Also, FHA loans allow for lower credit scores than conventional loans and the rules are more liberal since it accepts financial gifts from family members or grants as means of down payment. Another benefit of FHA is that individuals can assume someone else’s FHA loan by picking up the repayment process from where the initial party left off. However, FHA loans may involve closing costs which are not required for conventional loans.
A VA loan is a mortgage loan is a loan established in 1944 by the United States Department of Veteran Affairs. It is issued by private finance houses and backed by the above-named agency to assist US veterans, widowed military spouses as well as those in active service to buy a home. It is one of the two known non-conventional mortgage loans that is guaranteed by the government. This means the government will repay the remaining part of the loan if the borrower defaults in payment. Since VA loans are guaranteed by the government, they are relatively easier to access than conventional mortgage loans. Unlike FHA loans, VA loans do not carry any down payment. Also, they do not need any insurance premium requirement.
To be eligible for VA loans, the individual will have to meet specific service requirements. The eligibility falls under three categories:
– Spouse of a service member who died in the line of duty
– Personnel who has served more than six years in the National Guard or the Selected Reserve
– Personnel on active service or an honorably discharged veteran who has 90 consecutive days of active service during wartime or 181 days of active service during peacetime.
Asides that no down payment or insurance payment is required, the major benefit is that there is no limit of how much can be borrowed but there is a limit on the liability that the VA takes on. Although eligibility carries no minimum credit score requirement, lenders still look for borrowers with a minimum credit score of 620. Also, there is no prepayment penalty, meaning you won’t be fined if you pay off your loan early.
An Interest-Only Mortgage is a loan option whereby the borrower is required to pay the interest on the mortgage on a monthly basis over a specified period of time. The principal sum is repaid either through lump sum payment at a predetermined date or after the expiration of the interest payment period. Interest Only Mortgage is structured as a typology of an adjustable-rate mortgage. Interest Only Mortgage appeals more to individuals because it reduces mortgage payment drastically.
Interest Only Mortgages are structured severally. The interest payment may be made over a particular period, may be given as an option or may exist for the life of the loan. The most popular interest payment period is between five and ten years. After the expiration of the term, the loan becomes fully amortized and the borrower is required to start paying portions of the principal.
One benefit of Interest Only Mortgage is that during the interest-only period, the amount payable monthly qualifies as tax-deductible. While monthly payments are low during the interest-only period, the borrower may purchase a larger home by qualifying for such. However, there is a tendency for the interest rates to rise if the mortgage is scheduled as Adjustable-Rate Mortgage. Also, many people often find it difficult to afford the principal payments when the time eventually comes.
Components of an ARM
To have a perfect understanding of ARM, it is important to know the components. These include:
Index – this is the financial indicator that fluctuates based on economic activities. It serves as the basis for future interest adjustments of the loan. Mortgage houses use a variety of them.
Margin – this is the amount that is added to the interest rate, representing the lender’s cost of doing business plus the profit.
Amortization – This is a period of time when gradual repayment of debt occurs through systematic payments of the principal and any other accrued interest.
Negative Amortization – This occurs when payment is declared not sufficient enough to cover the loan interest, leading to a shortfall amount being added to the principal balance.
Note rate – this is the actual interest rate that is charged for a loan schedule.
Adjustment period – is the interval during which the interest is expected to change during the life of the loan.
Convertibility – is described as an option to change a mortgage loan from Adjustable-Rate to Fixed-Rate. It comes with a charge.
Initial Interest – this is a teaser rate. It is very low, is stated at the initial period of the loan and is used to entice buyer as well as enable them to qualify for the loan.
Interest rate cap – this is a limit that is placed as the highest and lowest points an interest rate can move within during a specific period or the life of the loan.
Carryover – an increment of interest rates beyond what is permissible by the caps which can be applied to future interest rate adjustments.
Commonly Used Indexes for ARM
There are several types of Arm indexes, with each having unique characteristics that set it apart from others. Some of the most popular indexes include the following.
The London Interbank Offered Rate (LIBOR) is a barometer used globally by investors based on the interest rates charged among London-based banks for borrowings among them. LIBOR, as a global index is used in an ARM to cover intervals ranging from one month up to a year. It is extremely volatile, as it changes on an almost daily basis.
This index represents that weekly average yield on US Treasury Securities that are adjusted to a one-year maturity. Often used for ARM loans, and is subject to changes only once every year.
Also, an index representing the average yield of US Treasury Securities, it is adjusted to three-year maturity. When used for ARM loans, it means that the interest will be adjusted every three years. It appeals to people who prefer loans with fewer interest rate adjustments.
Just the other US Treasury Bills, it represents a weekly average yield that is adjusted to five-year maturity. They are used for 5/5 ARM loans, with interest rate adjustments coming once in five years.
Prime is a rate set by the Federal Reserve for use by banks and credit unions, and it is the interest rate used by most commercial banks for their most trustworthy clients. It also serves as a basis for other interest rates and is used for adjustment of interest on long term loans at particular intervals.
A balloon mortgage is a kind of loan that has an initial period with little or no payment is made, and which at the end of the period, the borrower is expected to pay off the full balance with a lump sum. The loan is not amortized over its life; hence you do not have to eliminate the debt with a fixed interest plus principal payment monthly. Sometimes, there may be monthly payments of interest only and is often very low. It is the final lump sum expected to be paid that is referred to as the balloon payment. Balloon mortgages come in various forms, with the most popular being interest-only options that require the borrower to repay interest monthly and pay the lump sum at the end. In essence, balloon mortgage always has a lump sum to be paid at the end. Such loans are offered for a period between 5 to 7 years. It is ideal for individuals who intend to stay in their homes for a short period or those who are expectant of higher income in the near future. The only risk of balloon loan is that the homeowner has no equity in the house until the lump sum is paid. When a balloon loan payment is due, the borrower has an option to refinance it with a new loan agreement to extend the repayment period or sell it off to pay the lump sum. And if there are enough funds, the borrower may choose to pay off the lump sum when due.
A reverse mortgage is a loan program that people who are 62 years or older can borrow against the value of their home to receive funds either as a lump sum, fixed monthly payment or to access a line of credit. Unlike a forward mortgage where loan payments are made, reverse mortgages do not require that the homeowner make any loan payments. Rather the loan becomes repayable when the borrower dies, relocates from the home or sells it off. Reverse mortgages allow for individuals to convert part of their equity into cash without having to sell the home or pay additional monthly bills.
Reverse mortgages provide a means for old people whose net worth is tied up with real estate. However, they are often complex and expensive.it comes in there forms;
– Single-purpose mortgages which are offered by state and local governments as well as property managers and non-profit organizations. They are relatively small and can be used to cover just one specific purpose.
– Proprietary reverse mortgages which are in the form of private loans not backed by governments; and
– Federally-insured revere mortgages which are also referred to as Home Equity Conversion Mortgages (HECMs).
The amount that can be accessed from a reverse mortgage depends largely on certain factors such as the current value of the home, age, current interest rate as well as a financial assessment of the homeowner.
Graduated Payment Mortgage
A Graduated Payment Mortgage is a kind of fixed-rate mortgage wherein there is a gradual increment in the payment from an initially low base level to a higher final level. Typically, the payments may increase from 7% through 12% per annum from the initial base payment until it reaches the full amount to be repaid. It is designed in a way that allows the homeowner to start with minimum payments which subsequently increases overtime. It is very beneficial for individual who are expecting gradual increment in their income levels in the near future.
Graduated Payment Mortgage is only available on loans from the Federal Housing Administration (FHA), and is suitable for individuals who may not be able to make large down payments. Graduated Payment Mortgage may or may not a negative amortization loan. Graduated payment mortgage loans come in five distinct categories; three allow for mortgage payments to increase at rates of 2.5%, 5% and 7.5% respectively while the other two plans allow for payment increment at a rate of 2% to 3% annually over 10 years. The major disadvantage of this mortgage plan is that the total costs associated with it are relatively higher than traditional mortgages. And if it is a negative amortization loan, the borrower will even pay more interest on the loan. To be eligible, the individual must meet the credit requirements, cash investment and also be able to prove the capability of the mortgage payment.
Which Mortgage Plan is best for you?
Whether you are buying a home for the first time or not, applying and accessing mortgage loans come with its difficulties. With a vast array of programs to choose from, choosing the right mortgage plan is a daunting task. Since they carry separate repayment burdens, it is important to evaluate yourself very well to know which suits you the best.
The first thing is to figure out how much you can afford and if it is within your reach. This will depend on your income streams now and in future. It is also important to set savings for the upfront costs since lenders expect you to have some money in the bank as down payment, coupled with the closing costs. This may seem like a big task but it helps you cushion the purchase with a little home equity. You should equally consider the length of the mortgage loan to know how long you will be committed to repaying the loan. You must also be able to choose the right type of mortgage among the varieties of loan programs that exist; fixed-rate, conventional, interest-only, Conforming and Non-conforming loans etc.
Lastly, be knowledgeable on how the mortgage interest rates work so that you do not dip yourself into a mortgage program with an interest rate that is too bogus. You may need to lock in your loan’s interest rate over the long term or allow it to move with the market and be subject to adjustments periodically. No matter the loan type you are intending to access, be sure to check your credit report beforehand so that you can know your credit position.