Basics on Adjustable Rate Mortgages (ARM)
- An index
- A margin
- Adjustment Period
- An interest rate cap
- An initial interest rate
THE INDEXAn ARM’s interest rate is tied to one of many economic indices, some examples of which are the 1-year constant maturity Treasury security, the Cost of Funds Index, or the London Interbank Offered Rate. Different indices move at different rates so know the characteristics of the index used for your ARM.
THE MARGINThe interest rate for your ARM will be calculated by adding a margin to the interest rate from the index. The margin is basically the markup charged by the lender that allows them to make a profit off your loan, such as adding 2% to the index, where the 2% is the margin. The margin of your loan usually does not fluctuate.
THE ADJUSTMENT PERIODThe Adjustment Period controls when and how often your interest rate changes. For example, if your ARM has an adjustment period of 1 year, your interest rate will be subject to change at the end of each year and your monthly mortgage payment will be recalculated to reflect this change.
THE INTEREST RATE CAPInterest rate caps are built into the loan to protect the borrower from drastic interest rate fluctuations. The caps limit how much the interest rate or monthly payment can change at the end of each adjustment period. An ARM can also have a cap for the life of the loan. For example, during the life of a loan, the interest rate can only be increased by 5%.
THE INITIAL INTEREST RATEThe Initial Interest Rate is the interest rate that you start with at the beginning of your loan period. The length of time your loan stays at this rate is built into the loan. For example, you may stay at the initial interest rate for 1 year, 5 years, or another length of time depending on your specific mortgage. This type of ARM is generally referred to as a Hybrid ARM. The initial interest rate for an adjustable rate mortgage is generally lower than that of a fixed rate mortgage.
Pros & Cons of An Adjustable Rate Mortgage
Offering adjustable rates allows lenders to transfer part of the interest rate risk from themselves to the borrower. If you get a fixed rate mortgage and the interest rate goes up, it costs the lender money. However, if you have an adjustable rate mortgage, as the interest rate goes up, so does your payment, thus compensating the lender. Adjustable rate mortgages are particularly useful when unpredictable interest rates make fixed rate loans hard to get.
One of the main advantages of an adjustable rate mortgage is that the initial interest rate is lower than that of a fixed rate mortgage. A lower rate means lower payments, which may help you qualify for a larger loan. This is an important detail if you expect your future earnings to rise. In this case, the ARM will allow you to qualify for a larger loan amount earlier rather than later.
However, this information should only be used with care. If you use an ARM to qualify for a larger loan amount than a fixed rate would allow you and the interest rate rises drastically or your income doesn’t rise, you may not be able to afford the larger monthly payments, thus causing you to default on your loan.
An adjustable rate mortgage makes sense if you are only going to keep the house for a short time. If you are only planning to own your house for only a few years, the risk of the interest rate rising goes down. This means that you will get a better rate with an ARM, making it a good choice. However, if you plan to stay in your home for a long time, a fixed rate may be a better option.
It’s important to have a plan. Know what your goals are in purchasing a home and plan for all eventualities. Do your research when shopping for an ARM and consider the worst-case scenario.
What Is A FICO® Score?
- – Delinquencies
- – Too many accounts opened within the last twelve months
- – Short credit history
- – Balances on revolving credit are near the maximum limits
- – Public records, such as tax liens, judgments, or bankruptcies
- – No recent credit card balances
- – Too many recent credit inquiries
- – Too few revolving accounts
- – Too many revolving accounts
Types of Mortgage Lenders
Mortgage Bankers are lenders that are large enough to originate loans and create pools of loans, which are then sold directly to Fannie Mae, Freddie Mac, Ginnie Mae, jumbo loan investors, and others. Any company that does this is considered a mortgage banker.
Some companies don’t sell directly to those major investors, but sell their loans to the mortgage bankers. They refer to themselves as mortgage bankers as well. Since they are engaging in the selling of loans, there is some justification for using this label. You cannot reliably determine the size or strength of a particular lender based on whether or not they identify themselves as a mortgage banker.
An institution that lends their own money and originates loans for itself is called a portfolio lender. This is because they are lending for their own portfolio of loans and not worried about being able to immediately sell them on the secondary market. Because of this, they don’t have to obey Fannie/Freddie guidelines and can create their own rules for determining credit worthiness. Usually these institutions are larger banks and savings & loans.
Quite often only a portion of their loan programs are a portfolio product. If they are offering fixed rate loans or government loans, they are certainly engaging in mortgage banking as well as portfolio lending.
Once a borrower has made the payments on a portfolio loan for over a year without any late payments, the loan is considered seasoned. Once a loan has a track history of timely payments it becomes marketable, even if it does not meet Freddie/Fannie guidelines.
Selling these seasoned loans frees up more money for the portfolio lender to make additional loans. If they are sold, they are packaged into pools and sold on the secondary market. You will still make your loan payments to the same lender, which has now become your servicer.
Lenders are considered direct lenders if they fund their own loans. A direct lender can range anywhere from the biggest lender to a very tiny one. Banks and savings & loans obviously have deposits with which they can fund loans, but they usually use warehouse lines of credit for drawing the money to fund the loans. Smaller institutions also have warehouse lines of credit from which they draw money to fund loans.
Correspondent is usually a term that refers to a company that originates and closes home loans in their own name, then sells them individually to a larger lender, called a sponsor. The sponsor acts as the mortgage banker, re-selling the loan to Ginnie Mae, Fannie Mae, or Freddie Mac as part of a pool. The correspondent may fund the loans themselves or funding may take place from the larger company. Either way, the sponsor usually underwrites the loan.
There is usually a very strong relationship between the correspondent and their sponsor.
Mortgage Brokers are companies that originate loans with the intention of brokering them to lending institutions. A broker has established relationships with these companies. Underwriting and funding takes place at the larger institutions. Many mortgage brokers are also correspondents.
Mortgage brokers deal with lending institutions that have a wholesale loan department.
Most mortgage bankers and portfolio lenders also act as wholesale lenders, catering to mortgage brokers for loan origination. Some wholesale lenders do not even have their own retail branches, relying solely on mortgage brokers for their loans. These wholesale divisions offer loans to mortgage brokers at a lower cost than their retail branches offer them to the general public. The mortgage broker then adds on his fee. The result for the borrower is that the loan costs about the same as if he obtained a loan directly from a retail branch of the wholesale lender.
Banks and savings & loans usually operate as portfolio lenders, mortgage bankers, or some combination of both.
Credit Unions usually operate as correspondents, although a large one could act as a portfolio lender or a mortgage banker.
Closing Costs Associated With Lender
This is a detailed summary of costs you may have to pay when you buy or refinance your home. They are listed in the order that they should appear on a Good Faith Estimate you obtain from a mortgage lender. There are two broad categories of closing costs. Non-recurring closing costs are items that are paid once and you never pay again. Recurring closing costs are items you pay time and again over the course of home ownership, such as property taxes and homeowner’s insurance. Some of the items that appear here do not traditionally appear on a lender’s Good Faith Estimate and lenders are not required to show all items.
NON-RECURRING CLOSING COSTS ASSOCIATED WITH THE LENDER
Loan Origination Fee – The loan origination fee is often referred to as points. One point is equal to one percent of the mortgage loan. As a rule, if you are willing to pay more in points, you will get a lower interest rate. On a VA or FHA loan, the loan origination fee is one point. Any additional points are called discount points.
Loan Discount – On a government loan, the loan origination fee is normally listed as one point or one percent of the loan. Any points in addition to the loan origination fee are called discount points. On a conventional loan, discount points are usually lumped in with the loan origination fee.
Appraisal Fee – Since your property serves as collateral for the mortgage, lenders want to be reasonably certain of the value and they require an appraisal. The appraisal looks to determine if the price you are paying for the home is justified by recent sales of comparable properties. The appraisal fee varies, depending on the value of the home and the difficulty involved in justifying value. Unique and more expensive homes usually have a higher appraisal fee. Appraisal fees on VA loans are higher than on conventional loans.
Credit Report – As part of the underwriting review, your mortgage lender will want to review your credit history. The cost of running the credit report can vary and is included in closing costs.
Lender’s Inspection Fee – You find this fee on new construction and it is associated with what is called a 442 Inspection. Since the property is not finished when the initial appraisal is done, the 442 Inspection is done when the building is completed and verifies that construction is complete with carpeting and flooring installed.
Mortgage Broker Fee – About seventy percent of loans are originated through mortgage brokers and they will usually list your points in this area instead of the Loan Origination Fee category. They may also add any broker processing fees in this area so you clearly understand how much is being charged by the wholesale lender and how much is being charged by the broker. Wholesale lenders offer lower costs/rates to mortgage brokers than you can obtain directly, so you are not paying extra by going through a mortgage broker.
Tax Service Fee – During the life of your loan you will be making property tax payments, either on your own or through your impound account with the lender. Since property tax liens can sometimes take precedence over a first mortgage, it is in your lender’s interest to pay an independent service to monitor property tax payments.
Flood Certification Fee – Your lender must determine whether your property is located in a federally designated flood zone. This is a fee usually charged by an independent service to make that determination.
Flood Monitoring – From time to time flood zones are re-mapped. Some lenders charge this fee to maintain monitoring on whether this re-mapping affects your property.
Other Lender Fees?
Closing Costs Not Associated with Lender
REFINANCING ASSOCIATED COSTSInterest – When you close the transaction on your refinance, there will most likely be some outstanding interest due on the old loan. For example, if you close on August twentieth (and you made your last payment), you will have twenty days interest due on the old loan and ten days prepaid interest on the new loan. Your first payment on the new loan would not be until October 1st since you have already paid all of August’s interest when you closed the refinance transaction (since interest is paid in arrears, a September payment would have paid August’s interest, which has already been paid in closing). Reconveyance Fee – This fee is charged by your existing lender when they “reconvey” their collateral interest in your property back to you through recording of a Reconveyance. Demand Fee – Your existing lender may charge a fee for calculating payoff figures. Sub-Escrow fee – Though it sounds like an escrow fee, this fee is actually charged by the Title Company. Assume it is an income-generating fee similar to some of the lender fees mentioned above. Loan Tie-in Fee – This cost is actually charged by the Escrow Company. Homeowner’s Association Transfer Fee – If you are buying a condominium or a home with a Homeowner’s Association, the association often charges a fee to transfer their ownership documents to you.
Asking Seller to Pay Closing Costs - Rules & Advice
It has become common to ask the seller to pay some or all of the closing costs when you purchase a home. This is financing your closing costs since you will probably pay a little bit more for the property than you would if you were paying your own costs.
On conventional loans you can only ask the seller to pay non-recurring costs, not prepaid fees or items to be paid in advance. If you are putting ten percent or more down, the most the seller can contribute is six percent of the purchase price. If you are putting less down, the most the seller can contribute is three percent.
On VA loans, you can ask the seller to pay everything. This is called a “VA No-No”, meaning the buyer is making no down payment and paying no closing costs.
On FHA loans, the seller can pay almost any cost, but the buyer has to have a minimum three percent investment in the home/closing costs.
Most refinances include the closing costs and prepaids in the new loan amount, requiring little or no out-of-pocket expenses to close the deal.
What Item Are Required to Be Paid In Advance?
Pre-paid Interest – Mortgage loans are usually due on the first of each month. Since loans can close on any day, a certain amount of interest must be paid at closing to get the interest paid up to the first. For example, if you close on the twentieth, you will pay ten days of pre-paid interest.
Homeowner’s Insurance – This is the insurance you pay to cover possible damages to your home and other items. If you buy a home, you will normally pay the first year’s insurance when you close the transaction. If you are buying a condominium, your Homeowners’ Association Fees normally cover this insurance.
VA Funding Fee – On VA loans, the Veterans Administration charges a fee for guaranteeing your loan. The fee will be a percentage of the loan balance but the exact percentage will vary depending on whether you have used your VA eligibility in the past. Instead of paying this as an out-of-pocket expense, most veterans choose to finance it, so it gets added to the loan balance. This results in the loan balance on VA loans being higher than the actual purchase amount.
Up Front Mortgage Insurance Premium (UFMIP) – This is charged on FHA purchases of single-family residences (SFR’s) or Planned Unit Developments (PUDs). Like the VA Funding Fee it is normally added to the balance of the loan. Unlike a VA loan, the homebuyer must also pay a monthly mortgage insurance fee, too. This is the reason many lenders do not recommend FHA loans if the homebuyer can qualify for a conventional loan. Condominium purchases do not require the UFMIP.
Mortgage Insurance – Though it is rare nowadays, some first-time homebuyer programs still require the first year mortgage insurance premium to be paid in advance. Most mortgage insurance (when required) is simply paid monthly along with your mortgage payment. Mortgage insurance covers the lender and covers a portion of the losses in those cases where borrowers default on their loans.
Your Savings and Down Payment
YOUR FIRST STEP TOWARD BUYING A HOME
When preparing to buy a home, the first thing you should do – before you call on an ad, before you talk to your real estate professional, before you shop for interest rates – is look at your savings.
Because determining how much money you have available for down payment and closing costs affects almost every aspect of buying a home – including how you write your purchase offer, the loan programs you qualify for, and shopping for interest rates.
If you only have enough available for a minimum down payment, your choices of loan program will be limited to only a few types of mortgages. If someone is giving you a gift for all or part of the down payment, your options are also limited. If you have enough for the down payment, but need the lender or seller to cover all or part of your closing costs, this further limits your options. If you borrow all or a portion of the down payment from your 401K or retirement plan, different loan programs have different rules on how you qualify.
If you have enough for a large down payment, then you have many choices.
Your loan choices include such varied programs as conventional fixed rate loans, adjustable rate mortgages, buydowns, VA, FHA, graduated payment mortgages and all the varieties of each.
SHOPPING FOR RATES
Some loan programs charge a slightly higher interest rate for minimal down payments. Plus, the interest rates for different loan programs are not the same. For example, conventional, VA, and FHA all offer fixed rate loans. However, the rates vary from one program to another.
If you shop lenders by phone, the loan officer will be able to tell you which programs fit and quote your rates accordingly. However, if you are shopping on the Internet, you have to develop some idea of your loan program on your own.
WRITING YOUR OFFER
You need to have a clue about your down payment because it affects how you write your offer to purchase a home. Not only are you required to put your down payment information in the offer, but also different loan programs have different rules that also affect how you write your offer. This is especially important when dealing with FHA and VA loans.
If you are asking the seller to pay all or part of your closing costs, you must be certain your loan program allows what you are asking. For smaller down payments, lenders allow the seller to pay less closing costs than for larger down payments. Some loan programs will allow a seller to pay certain types of costs, but not others.
Finally, your down payment also affects your ability to qualify for a loan. When you make a small down payment, lenders are strict about having you conform to their underwriting guidelines. For larger down payments, they will tend to make allowances or exceptions to the rules.
The down payment affects every choice you make when you buy a home and the first thing you should do is figure out how much money you have available for the purchase.