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Instead of a
"Fixed"Interest Rate for the entire life of the loan, "Adjustable"Rate
Mortgages have an Interest Rate that "Adjusts"periodically during the life of
the loan. How often the rate adjusts varies from loan to loan. It can adjust every month,
every year,every 3 years or every 5 years. Or, you can get an adjustable mortgage that has
a "Fixed" interest rate for the first 3,5,7 or 10 years and then the rate
adjusts every year for the remainder of the loan.
The Interest Rate is determined by adding two components: the "Index" and the
"Margin". The "Index" is usually a 1,3,or 5 year Treasury Security
Rate or a short term "Cost of Funds" Index that is used by Savings & Loans.
The "Margin"is set by the Lender and is added to the "Index". This
provides the Lender with a profit margin to offset the cost of the funds to the Lender. As
example, if a Savings & Loan pays it's depositors 3% on 5 year Certificates of
Deposit, and then turns around and loans that money to you, the Lender has to make a
profit in order to cover his costs and the risk that you will repay the money since the
Lender has to pay the depositor back as well. If the "Index" is based on the 3
year T-Note and is currently 3.50% and the "Margin" is 2.50% then the interest
rate on the Adjustable Loan will be 6.00% ( 3.50%+ 2.50% ). This gives the Lender a spread
to cover his costs and risks. As interest rates go up and the lender has to pay depositors
higher rates to keep them as depositors, the interest rate on the Adjustable Rate Mortgage
also goes up to help keep the profit spread in tact for the lender.
Adjustable Rate Mortgages also have "Caps". There are 3 "Caps": 1.
"Periodic Cap" -This limits the amount of increase or decrease that the interest
rate can be adjusted from one adjustment period to the next. If the Periodic Cap is 2% as
example, then the interest rate can only move from 5% to 7% at any one Adjustment Period.
If interest rates go up by 3 full percentage points and the loan has a "Periodic
Cap"of 2%, then the interest rate cannot go up 3% to match the increase in interest
rates, it can only go up 2% because of the "Cap".2. "Overall Cap" -
Also know as the "Life Cap", limits the amount of increase or decrease in the
interest rate over the entire life of the loan. If, as example, the "Overall
Cap" is 5%, then the interest rate cannot go up by more than 5% over the life of the
loan. If the rate started at 6% and had a 5% "Overall Cap", the rate could never
exceed 11%.3. "Payment Cap" -This limits the % increase of the monthly payment
regardless of the increase or decrease in the interest rate. As example, if the loan has a
7% "Payment Cap" and the monthly payment is $500, the new monthly payment at the
Adjustment Period cannot go up by more than $35 ( 5% of$500), regardless of how much the
interest rate moves up. If,however, the interest rate goes up and the monthly payment has
a "Payment Cap" that restricts the monthly payment to an amount that is lower
than the amount that would pay at least the interest at the new higher interest
rate....then the shortfall in the payment would be added to the Principal amount of the
loan.This is know as "Negative Amortization" and causes the Principal Balance
you owe to increase rather than decrease as the loan goes on.
The Adjustable rate Mortgage starts off with an "Initial" Interest Rate.Also
know as the "Intro" Rate, moneylenders will offer you an "Initial"
Rate that is lower than the current market rate as a bonus to apply with them for your
loan. Be aware that the "Initial" or "Intro"rate is only good for a
specific period of time and will not be the rate you will have to pay after that period is
over. Always ask if the rate you are being quoted is an "Initial"Rate and how
long is that rate effective. Then ask what the rate would be if there was NO
"Initial" Rate. This will give you an idea of what you will be paying after that
first "Intro"period is over. If there is no "Initial" Rate than the
rate will be the current "Index" + the "Margin".Therefore, you need to
know what the current "Index"is and add that to the "Margin" you got
in "P"above. As example, if the "Index" for this loan is 3%and the
"Margin" is 2%, then you beginning interest rate will be 5% ( 3% + 2%), which
will last until the first Adjustment Period.
How "Adjustable" Interest Rates are Determined:
The Interest Rate is "Adjusted" Periodically (Usually once a Year).
The "Adjustment" is based on:
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Index
(Usually the 1 Year T-Note) |
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Margin
(Set by the Lender to cover his costs and provide a profit) |
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Interest Rate ( What you pay on loan) |
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How "Initial" or "Intro" Interest Rate Works :
The "Initial" rate is only good for a specific period of time, after which the
"Index" + "Margin" kick in to produce the interest rate you pay for
that period.
As example, here is how a $100,000 Loan with the "Index" at 3% and the
"Margin" at 2% works after an "Initial" Rate of 2%.
|
"Initial"
Rate Period |
Immediately
After "Initial" Rate Period |
Rate |
Monthly Payment |
Rate |
Monthly Payment |
2% |
$370 |
5% |
$537 |
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Examples:
Lets look as several examples of how "Adjustable" Rate Mortgages work
in several different interest rate scenarios.
The example uses a $100,000 Adjustable Rate Mortgage with an "Initial" Interest
Rate of 3%. After that, the Interest Rate is Adjusted each Year and based on : The
"Index", which is the 1 Year T-Note and the "Margin", which is 2%.
We show what happens if the 1 Year T-Note were to RISE each year by 1 Percentage Point
from 3% to 11% (over the next 8 years). And because your interest rate is based on the 1
Year T-Note "Index", then the increase in the Yield on the 1 Year T-Note over
the next 8 years effects your rate.
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|
End of
Yr 1 |
End of
Yr 2 |
End of
Yr 3 |
End of
Yr 4 |
End of
Yr 5 |
End of
Yr 6 |
End of
Yr 7 |
End of
Yr 8 |
Yield on 1 Yr T-Note |
4% |
5% |
6% |
7% |
8% |
9% |
10% |
11% |
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Example #1 - How your payments are effected by an increase in interest
rates over 8 years with NO "Caps".
|
|
Initial Rate |
End Yr 1 |
End Yr 2 |
End Yr 3 |
End Yr 4 |
End Yr 5 |
End Yr 6 |
End Yr 7 |
End Yr 8 |
Rate |
3% |
6% |
7% |
8% |
9% |
10% |
11% |
12% |
13% |
Monthly Pmt |
$422 |
$600 |
$665 |
$734 |
$805 |
$878 |
$952 |
$1,029 |
$1,106 |
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Comments: If you obtain an "Adjustable" Rate Mortgage Loan,
after the "Initial"Rate, your Interest Rate will go up to the Index Rate Plus
the Margin. And then after that your Interest Rate can rise each Year if the Index Rate
goes up like it does in this example. With No Caps, your monthly payment could be
substantially higher than you Initial payment as rates increase. |
Example #2 - How your payments are effected by an increase in interest
rates over 8 years with a 1% "Periodic Cap".
|
|
Initial Rate |
End Yr 1 |
End Yr 2 |
End Yr 3 |
End Yr 4 |
End Yr 5 |
End Yr 6 |
End Yr 7 |
End Yr 8 |
Rate |
3% |
6% |
7% |
8% |
9% |
10% |
11% |
12% |
13% |
Monthly Pmt |
$422 |
$600 |
$665 |
$734 |
$805 |
$878 |
$952 |
$1,029 |
$1,106 |
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Comments: If you obtain an "Adjustable" Rate Mortgage Loan,
after the "Initial"Rate, your Interest Rate will go up to the Index Rate Plus
the Margin. And then after that your Interest Rate can rise each Year by only 1% at each
"Adjustment Period"because of the "Periodic Cap". Because the Index
Rate increased by 1% and the "Periodic Cap" is also 1%, then your interest rate
will increase by 1% each year. |
Example #3 - How your payments are effected by an increase in interest
rates over 8 years with a 1% "Periodic Cap" AND a 5% "Overall or Life
Cap".
|
|
Initial Rate |
End Yr 1 |
End Yr 2 |
End Yr 3 |
End Yr 4 |
End Yr 5 |
End Yr 6 |
End Yr 7 |
End Yr 8 |
Rate |
3% |
6% |
7% |
8% |
9% |
10% |
11% |
11% |
11% |
Monthly Pmt |
$422 |
$600 |
$665 |
$734 |
$805 |
$878 |
$952 |
$952 |
$952 |
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Comments: If you obtain an "Adjustable" Rate Mortgage Loan,
after the "Initial"Rate, your Interest Rate will go up to the Index Rate Plus
the Margin. And then after that your Interest Rate can rise each Year by only 1% at each
"Adjustment Period"because of the "Periodic Cap" AND only up to a
TOTAL increase of 5% because of the "Overall Cap". Because the Index Rate
increased by 1% and the "Periodic Cap" is also 1%, then your interest rate will
increase by 1% each year, until year #7. The 5% "Overall Cap" keeps the interest
rate at 6% + 5% Cap which equals 11% Max over the life of the loan. (The
"Initial" Rate does not count as the Rate the Caps are added to, since it was
only an "Intro Rate" good for only a specific period of time). |
Example #4 - How your payments are effected by an increase in interest
rates over 8 years with a "Payment Cap" of 5% of the monthly payment.
|
|
Initial Rate |
End Yr 1 |
End Yr 2 |
End Yr 3 |
End Yr 4 |
End Yr 5 |
End Yr 6 |
End Yr 7 |
End Yr 8 |
Rate |
3% |
6% |
7% |
8% |
9% |
10% |
11% |
11% |
11% |
Monthly Pmt |
$422 |
$600 |
$630* |
$662* |
$695* |
$730* |
$767* |
$805* |
$845* |
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* The monthly payment cannot go up by more than 5% of the previous monthly payment because
of the "Payment Cap".
Comments: If you obtain an "Adjustable" Rate Mortgage Loan,
after the "Initial"Rate, your Interest Rate will go up to the Index Rate Plus
the Margin. And then after that your Interest Rate can rise each Year by only the
"Payment Cap" restriction of 5% of the previous monthly payment. However,
because the Index Interest Rate goes up each year, the payment you are allowed to make of
only 5% higher than the previous payment, will cause your payment to be lower than the
actual interest portion due on your loan. This means that whatever you are short on the
interest, will be ADDED to the Principal of your loan. This is called "Negative
Amortization" and means that you could owe more principal at the end of your loan
than your originally borrowed.. (The "Initial" Rate does not count as the Rate
the Caps are added to, since it was only an "Intro Rate" good for only a
specific period of time). |
Example #5 - How your payments are effected by an increase in interest
rates over 8 years if you went with a 3/5 Adjustable Rate Mortgage, which means your
interest rate is "Fixed" for the first 3 years and then adjusts each year for
the remained of the loan. We will use a "Fixed" rate of 5% for the first 3 years
of the loan and a 1% "Periodic Cap" on the rate after the first 3 years are
over.
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|
Initial Rate |
End Yr 1 |
End Yr 2 |
End Yr 3 |
End Yr 4 |
End Yr 5 |
End Yr 6 |
End Yr 7 |
End Yr 8 |
Rate |
5% |
5% |
5% |
8% |
9% |
10% |
11% |
12% |
13% |
Monthly Pmt |
$536 |
$536 |
$536 |
$734 |
$805 |
$878 |
$952 |
$1,029 |
$1,106 |
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Comments: In this example, you interest rate starts off at 5% and stays
there for the first 3 years of the loan. Then, the monthly payment for year #4 will be the
"Index" + the "Margin". In our example, because interest rates have
gone up and the 1 year T-Note is 6% going into year #4, our interest rate will be 6% + the
2% "Margin" for a total rate of 8%. (The 1% "Periodic Cap" is not
based on the "Fixed" interest rate of 5% unless that option is spelled out in
the loan documentation up front.) You would use this type of "Adjustable" Rate
Mortgage if you expected interest rate to go UP over the first 3 years of the loan. In
fact, if you felt rates were going up over a longer period of time, then you would want
the 5/1, 7/1 or 10/1 so that you got a "Fixed" rate for the first 5,7 or 10
years of the loan. |
SUMMARY:
As you can see from our 5 examples above, if you elect to go with an
"Adjustable" Rate Mortgage Loan, you want one with the smallest
"Margin" and the smallest "Periodic Cap" and smallest "Overall
Cap". This will keep your interest rate down in the event that interest rates rise
substantially over the life of your loan. And don't be fooled by the "Initial or
Intro" Interest Rate since it will only be good for a specific period of time and
after that the rate will rise to the "Index" + "Margin". And if you
feel that interest rates will be going up over the next 3 or 5 years, then you would want
the 3/1 or 5/1 "Adjustable" rate mortgage with a "Fixed" interest rate
for the first 3 or 5 years.
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Please also
visit the following related links:
- 30 Year & 40 Year
"Option" Adjustable Rate Mortgage Program
- Adjustable Rate
Mortgage with Fixed Rate Option
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