Saturday, December 29, 2007

The Anatomy of an ARM

It’s all over the financial news – interest rates are the lowest they’ve been in a decade. Because rates are extremely low, more people are thinking about becoming homeowners, and existing homeowners are thinking about refinancing. So for those of you considering delving into the complex world of home loans, here’s a primer on one of the most confusing loans out there – the Adjustable Rate Mortgage, or ARM.

ARM’s were designed in the 1970’s to help those who might not qualify for more traditional, fixed rate loans. As the years went by, ARM’s got “twisted” until today we have a myriad of loan products with a multitude of features.

However, all ARM’s have one thing in common – the interest rate “adjusts” rather than stays “fixed” over the life of the loan. So whatever ARM rate your loan agent quotes you, one thing is certain – it will change as the loan matures. How often the ARM rate changes is up to the bank. Some adjust monthly, some yearly. But how much it changes is a function of its index.

An index, in lending terms, is that interest rate a lender chooses as a baseline for your loan. In simple terms, it is the wholesale rate the lender pays for money. As the cost of money constantly changes, so too does the baseline interest rate used to calculate your loan payments. This is the component of your loan that “adjusts”. Lenders use different indices. These indices vary in both rate and stability. Some, like the 11th District Cost of Funds, are quite stable, i.e. they move very slowly and in small increments. Some, like the T-Bill Rate, move rapidly. Ask what index your loan is tied to, what that index’s rate is, and how often and how widely it fluctuates.

The next most important factor affecting your loan rate is the margin. To continue the retail analogy, this is the lender’s profit margin. There is no magic formula for this number. It is simply what the lender feels he needs (or can get) to make lending profitable. It is the combination of the index rate (wholesale cost) and the margin (profit) which determines your loan’s interest rate (retail cost).

Points and fees are the final pieces needed to understand the loan puzzle. Like margins, they are added on as a source of additional profit for the lender. The higher the margin, the lower the points. For example, a lender might offer a loan with a margin of 2.5 and 1 point, or the same loan with a margin of 2.75 and ½ point. Each point equals 1% of the loan amount.

Fees are also variable. Some lenders charge a separate fee for each service they provide – appraisal, documents drawing, underwriting, etc. Others charge a single flat fee for all these services. What matters is the total cost.

One last note…most lenders allow for a variety of payment plans on ARM’s. You can chose to pay the fully amortized 30 year rate or the fully amortized 15 year rate. You may decide to pay only the interest. Some lenders even allow you to pay a reduced payment. This usually results in “negative amortization” where the monthly payment is insufficient to cover even the interest due, so the balance is added back on to the loan principal. This will result in a larger loan balance.

When you are trying to compare ARM’s, be sure to ask about the index, margin, and points and fees. Lending is filled with confusing jargon. Don’t allow a loan agent, using a few unfamiliar terms to arm twist you into getting a lousy loan!

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