Common program names are Option ARM, Pick-A-Payment Loan, Flexible Payment Loan, Negative Amortization Loan, Monthly Adjustable, as well as others. There are as many variances of the same loan type as there are lenders offering them. Some monthly adjustable loans will begin with a "fixed" interest rate as low as 1%. That rate, however, may be good for as little as one month.
Adjustable Rate Mortgage interest rates are made up of two things – the Index value (the portion that fluctuates) and the fixed Margin. Combined they equal the interest rate charged on your loan. The Index (Treasury-based, LIBOR, COFI, COSI, etc.) can fluctuate monthly, semi-annually or annually depending on the product. Therefore, the interest rate you are paying may go up, down or stay the same with every index adjustment. The Margin is fixed for the life of the loan. The margin is set by the lender. If you are working with a mortgage broker, the margin will be priced higher according to the amount of lender-paid compensation. Mortgage brokers can receive in excess of 3% of the loan amount in lender-paid compensation, yet the low minimum payment will remain the same.
Common program names are Option ARM, Pick-A-Payment Loan, Flexible Payment Loan, Negative Amortization Loan, Monthly Adjustable, as well as others. There are as many variances of the same loan type as there are lenders offering them. Some monthly adjustable loans will begin with a "fixed" interest rate as low as 1%. That rate, however, may be good for as little as one month. The "fully-indexed" interest rate would then be charged from month two forward. The low payment option will be based on the start-rate or payment rate. Ranging from 1%-3% or higher, the low payment option may not cover all of the interest due. This results in negative amortization, or deferred interest. The unpaid interest is added to the outstanding loan balance. Each year the minimum payment will increase by a previously determined percentage until the borrower is paying the full principal and interest amount. Thereafter, the payment will adjust as needed based on the changes in the index value.
Beware the Recast. Borrowers must read the fine print – these loans are subject to a maximum amount of deferred interest and the loans may need to be recast. While the recast period varies by lender as well, most loans will recast in year 5. If needed, the loan will recast every 5 years. The combination of a very low payment and a rapidly increasing index value may lead to a recast even sooner. For example, a $300,000 loan with a 1% minimum payment, 6.5% fully-indexed rate increasing .5% each year for the next 3 years would reach the 110% maximum deferred interest point before the end of year 4. In this scenario, the loan amount will have ballooned to approximately $335,000. With a then current interest rate estimate of 8% and 25 years remaining on the loan, the fully-indexed payment would then be $2,585 per month. The original 1% payment would have been $965 per month. Therefore, the borrower would have to be able to afford the $2,585 payment or consider refinancing, selling, etc.
There is good news. When a borrower understands the financial benefits and the best monthly adjustable/lender combination is selected, there is little concern about a recast period or unaffordable monthly payments in the future. For example, a lender offering a 2.4% minimum payment, 10 year recast period, with a 6% fully-indexed rate increasing .5% each year for the next 3 years would not reach the maximum deferred interest point. This type of monthly adjustable would most likely never have to recast either. This more conservative approach can provide borrowers with the financial benefits for which the loans were initially intended.
If deferred interest is so good, why not take as much as possible? In response to a need for more financially beneficial home financing, the monthly adjustable provides homeowners a valuable feature: Options. For borrowers who are financially savvy, and those who are in control of their finances, this loan program provides short- and long-term benefits, especially when combined with a true bi-weekly payment. For the 2.4% minimum payment option above, the difference between the low payment of $1,169 and the full payment of $1,799 is $629 per month or $7,555 in the first year. The deferred interest is only $3,872 or just over 1% of the original loan amount. If the $7,555 were to be contributed on a pre-tax basis to an employers 401k match program of 50%, the borrower would then have added $11,332 to his/her retirement account in just one year. For those in the 15% tax bracket, there would also be an additional $1,133 tax savings on the $7,555.
While this may be Greek to some, it is the kind of consultation that should be provided to borrowers when they are shopping for a home loan. "What would you pay a mortgage consultant who shows you a way to own your home free and clear in about 23 years, while creating a retirement account of $166,000 or more with just the cash flow from the first 5 years of the loan?" says Michael Sanborn, President of Saint Lawrence Mortgage. Seattle Mortgage Broker "Borrowers need to know that a 30 year loan paid on a monthly basis will still owe half of the original loan amount after 21 years. Taking the extra time to develop a financial plan for a borrower can mean the difference between cat food and caviar in retirement."
