Yale Roth M.A., M.Ed

Archive for the ‘Adjustable Rate Mortgages (ARM)’ Category

I get the mortgage question a lot about how much does the mortgage rate have to drop before it makes sense to refinance the existing mortgage.

This morning a homeowner I was talking to was under the impression he needed to drop his mortgage rate by 2% in order to justify refinancing his mortgage.

Here’s are the 2 reasons why the 2% rule doesn’t make sense.

Reason #1.  In addition to the mortgage rate drop, you want to look at the mortgage payment.

Let’s say you’re only dropping your mortgage rate by .75% but your mortgage payment is dropping by $100 per month.

If one of your goals is to improve your monthly cash flow by lowering your mortgage payment, you just accomplished that and you only dropped the mortgage rate by .75%.

Reason #2 why you don’t have to drop your mortgage rate by 2% to refinance your existing mortgage to justify refinancing your mortgage.

Let’s say that you dropped your mortgage rate by .75% and you’re saving $100 per month.

Let’s also say that the closing costs to do that are only $1200.  That means that it’ll take you 1 year to recoup your closing costs.

That’s a short recoup period and makes sense as long as you plan on keeping the mortgage for at least 1 year and aren’t losing equity by resetting the mortgage term back to the orginal mortgage term.

In conclusion, the 2 reasons why you don’t have to drop your mortgage rate by at least 2% to justfy refinancing your mortgage are as follows: if you can lower your mortgage rate (even .5%), save money each month by lowering the mortgage payment, you can recoup your closing costs within 1 year and you’re not losing a lot equity by resetting the mortgage term more than 2 or 3 years, a mortgage rate reduction less than 2% makes sense.

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Does It Make Sense To Pay Discount Points On An Adjustable Rate Mortgage?

Paying discount points to get a lower mortgage rate is a question I get from time to time.  Most homeowners and first time home buyers treat discount points or “points” like the plague.

Most homeowners and first time home buyers don’t realize what points are and how they can benefit the borrower.

However, the mortgage question is “Does it make sense to pay discount points to get a lower mortgage rate for an adjustable rate mortgage?”

Before I answer the mortgage question, I want to define what discount points are and why some homeowners or first time home buyers will pay them.

Discount points represent 1% of the loan amount and are used to buy the mortgage rate down.

Discount points – not origination points – are prepaid mortgage interest that  the homeowner or first time home buyer is paying upfront at closing to get a lower mortgage rate knowing that over time the homeowner or first time home buyer will save movey with the  lower mortgage rate.

Paying discount points can be useful and can save the homeowner or first time home buyer money over time.  Time is the critical factor here because the homeowner or first time home buyer has to keep the mortgage long enough to recover the upfront costs (or points.)

That’s why it DOESN’T make sense to pay discount points to get a lower mortgage rate if you’re in a an adjustable rate mortgage, also known as a ARM.

The reason is because the mortgage rate in the adjustable rate mortgage is fixed for a certain amount of time, then adjusts.

So the problem is that the mortgage rate can change or adjust before the homeowner or first time homebuyer recovers their upfront points.

In conclusion, homewoners and first time home buyers – it doesn’t make sense to pay discount points to get a lower mortgage ratre if you’re applying for an adjustable rate mortgage.

You have to do the math to calculate the recovery period, but in all liklihood – you will not have enough time to recover your upfront discount points  before the mortgage rate adajusts.

The way to calculate this is to compare the mortgage payment for two different mortgage rates.

Take the difference in mortgage payment and divide it into the difference in lender fees – with discount points and without discount points.  This will tell the homeowner or first time home buyer how long it’ll take to recoup the upfront discount points.

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To answer the mortgage question: “Which is a better loan type: a fixed rate mortgage or adjustable rate mortgage?” it’s important first to define each loan type first.

What is a fixed rate mortgage?

A fixed rate mortgage is based on a fixed mortgage rate that doesn’t change through the term of the loan.  The mortgage is amortized based off that mortgage rate and mortgage term.  The mortgage will be paid off and satisfied at the end of the mortgage term.

So, for example, on a 10 year fixed mortgage, if the mortgage rate is 3.5%, that 3.5% mortgage rate won’t change.  Also, at the end of 10 years, the mortgage will be paid off.

Here are benefits of a fixed rate mortgage.

1. The mortgage rate is fixed so you know what your’re being billed at, no matter where the mortgage rates are.  So, if you’re locked into 3.5%, if the prevailing mortgage rates are 7%, you’re secure at 3.5%.

What is an Adjustable Rate Mortgage also known as an ARM?

An adjustable rate mortgage ARM offers a mortgage rate that is fixed for a certain amount of time: either 3, 5, 7, or 10 years.

After that fixed period is up, the mortgage rate adjusts to the yield on a specific index.  In addition to the yield on the index, there will be a “margin” attached to the yield.  The margin varies from 2.25% to 2.75%, usually.

So if the yield on the index after your fixed period is up is 4.1% – let’s say – we add the margin of 2.25% – let’s say – to get a “bill rate” of 6.35%.

This will be the mortgage rate that you’ll be billed at for 1 year after the fixed period lapses.

One year from the first adjustment day, the mortgage will do the same thing all over again – look at the yield on the index and add the margin to it.  That will be your bill rate for the next year.  The mortgage rate will continue to change every year thereafter until the term is satisfied.

There are mortgage rate caps that are placed on the adjustable rate mortgages.

For example, a common “cap structure” is what’s called 5/2/5.

That means that the most your mortgage rate can increase to after the fixed period lapses is 5% over the initial start rate.  This is also the lifetime cap on the mortgage.

So if your start mortgage rate is 3.5%, the most the mortgage rate can increase to through the lifetime of the loan is 8.5%.

Adjustable rate mortgages ARMs are amortized over a 30 year period.

The index that are tied to the adjustable rate mortgages is typically the LIBOR index.  LIBOR stands for the London Interbank Offered Rate.

What’s the benefit of the adjustable rate mortgage?

If you know that you’re only going to own the home for a specific amount of time, like 5 years, you may want to consider an adjustable rate mortgage because the mortgage rate will be lower than the 30 year fixed mortgage rates.

With the lower mortgage rate and lower mortgage payment, you’re saving money from a monthly cash flow perspective.

The draw back of the adjustable rate mortgage ARM is that the mortgage rate and mortgage payment can change after the start rate period lapses.

To answer the mortgage question “are you better off with a fixed rate or adjustable rate mortgage” it just depends how long you plan on keeping the home, what the monthly savings is by going with the adjustable rate mortgage and whether that savings and mortgage affordability justifies the risk that the mortgage rate can change after a certain amount of time.

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Out of all the mortgage questions I get, this mortgage question is asked every now and again: “Are Adjustable Rate Mortgages That Bad”?

When determining what loan type someone is interested in, I ask, “Are you looking for a fixed rate mortgage or an adjustable rate mortgage.” Typically I get the answer, “No way do I want an adjustable rate mortgage.”

Adjustable rate mortgages, also known as ARMs, are not necessarily bad loan types.  It just depends what your objectives regarding the mortgage are.

Here’s a breakdown of the pros and cons.

The Pros.

1. Often times the mortgage rate and mortgage payment are lower than the fixed rate mortgage, especially the 30 year fixed mortgage.

2. The lower mortgage rate will provide additional monthly savings – in comparison to the 30 year fixed mortgage.  Cash is king.  It’s critical to save that difference; don’t spend it or get into the loan because you cannot afford a 30 year fixed rate mortgage payment.

The Cons.

1. The mortgage rate and mortgage payment can adjust after a certain amount of time. The fixed amount of time can range from 3 years to 10 years.

Why Would You Want An Adjustable Rate Mortgage ARM?

The reason people get into these loan types is because they know they will be selling the home within a certain time frame – like 3, 5, 7 or 10 years. Given this, why would they want a 30 year fixed mortgage, which would offer a higher mortgage rate and mortgage payment?

So, if you know that you’re only going to be in the home for 5 years – say – and you can save $150 month on a 7 year adjustable rate mortgage in comparison to a 30 year fixed mortgage, consider the 7 year ARM. Take the difference that you’re saving in mortgage payment and save it or apply it to principal reduction.

For example, if you take $150 and save it for 5 years or 60 months, you’ll have saved $9000, without earning any interest.

Please note that I’m comparing adjustable rate mortgage payments (which are amortized over a 30 year period) to a 30 year fixed mortgage payment. To compare the adjustable rate mortgage payment to a shorter term loan like a 15 year or 10 year fixed isn’t good comparison because with the shorter term mortgages, you’re going to build equity in your home faster than you would with an adjustable rate mortgage (unless you pay additional towards principal reduction on the adjustable rate mortgage.)

If you want to build home equity faster, then a shorter term loan would be worth considering.

However, if you know that you’re only going to own the own for a short period of time and don’t care about building home equity but would rather save the cash, an adjustable rate mortgage is worth considering.

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I get a lot of questions asking how an adjustable rate mortgage also known as an ARM works.

Here’s the mortgage answer.

The adjustable rate mortgage rate is fixed for a certain amount of time: either 3 years, 5 years, 7 years, or 10 years.  After that fixed period is up the mortgage rate and payment will adjust.

What will the mortgage rate adjust to?

The adjustable mortgage rate will adjust to the yield on a specific index - most commonly is the LIBOR (London Interbank Offered Rate) index PLUS a margin.  The margins range from 2.25% to 2.75%.  So if the yield on the LIBOR index is 2% and the margin – which is fixed and can never change – is 2.25%, your bill mortgage rate will be 4.5%.  Pretty easy.

Let’s say that you’re in a 5/1 ARM.  The 5 stands for the amount of years the mortgage rate and payment are fixed.  The 1 means that your mortgage rate can change every 1 year thereafter until the loan is paid off.

Adjustable rate mortgages are amortized over a 30 year term.

So to use the previous example of the 5/1 ARM, your mortgage rate is fixed for 5 years, after which time it will adjust one time a year.  The ARM rate will adjust on an “anniversary date” until the mortgage is paid off.

Let’s say the “anniversary date” is April 1.  So every April 1, the mortgage rate will reset to the yield on the LIBOR index – which moves and is variable – plus the margin – which is fixed.

How high can the mortgage rate go?

The mortgage rate on the adjustable rate mortgage is capped.  The most common “cap structure” is called a 5/2/5 cap structure.

What this means is that the mortgage rate can move up to 5% over the start rate, which is the mortgage rate you had for the fixed period.  Once the first adjustment is made to the mortgage rate, it’s fixed for one year.  Then on the mortgage “anniversay date,” the mortgage rate will adjust again, but cannot increase more than 2% per year for every year thereafter.

No need to panic, as the last 5 in the 5/2/5 represents the lifetime mortgage rate cap on loan.  So if the start rate was 4%, the most the mortgage rate can increase over the life of the loan is to 9% (i.e. 4+5=9).

So the interest rate may creep up 2% ever year after the fixed rate period lapses, but it cannot exceed 5% over the start rate.

Here’s an example:  5/1 ARM.

The start rate is 4% and is fixed for 5 years.  After the 60th month, the mortgage rate goes to to yield on the LIBOR index plus the margin.  Let’s say the LIBOR is at 4%.  So, 4% plus the margin (let’s say 2.25%) is 6.25%.

The mortgage rate is now 6.25% for the 6th year of the mortgage.

Now going into the 7th year, let’s say the LIBOR index is at 8%.  8% plus the margin of 2.25% equals 10.25%.  However, the 2% yearly mortgage cap will limit the rate to 8.25%.  That mortgage rate and payment are fixed for the 7th year.

Going into the 8th year, let’s say the LIBOR is at 8.5%.

8.5% plus 2.25% = 10.75% however the most your mortgage rate can increase is to the lifetime cap of 9% (which was the inital 4% start rate plus the 5% cap.)

This is how an adjustable rate mortgage works.

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I get a lot of questions about adjustable rate mortgages also known as ARMs.

The question I get the most is: “Should I take an adjustable rate mortgage (ARM) out on my home?

Here’s the answer.

It depends on what your objectives are.  The main question I ask to you is “how long do you plan on keeping the home”?

If you plan on keeping the home for a short period of time, then an adjustable rate mortgage may be a better or less expensive way to go.  Adjustable rate mortgage (ARM) interest rates are typically lower than a fixed rate mortgage rates, so the payment will be lower.  Also adjustable rate mortgages are amortized over 30 years.  So even though the mortgage rate may adjust, the mortgage payment and principal loan are still based on a 30 year period.

For example, if you know you’re going to be in your home for no more than 5 years, you may want to consider a 5/1 ARM, or 7/1 ARM.  These mortgage rates and payments are fixed for 5 yr or 7 years, so you will be protected while you own the home.

After the 5 or 7 years lapse, the mortgage rate will adjust and so will your payment – sometimes up and sometimes down.

If you’re not afraid of risk and you plan on keeping the home for a specific amount of time and you are confident you’ll be out of the home within that time period, then look at the adjustable rate mortgage that will protect you through that time period.

Look at the payment as well and compare that to a 30 yr fixed mortgage rate and payment.  See what the difference in payment and interest rate are.  Compare it to the adjustable rate mortgage ARM rate.  Are the lower mortgage rate and payment the adjustable rate mortgage is offering worth going into?

If you believe the savings is justified as the adjustable rate mortgage rates and payments will be typically lower than the 30 year fixed mortgage rates, then the adjustable rate mortgage is for you.  If not, stay with the conservative loan – the 30 yr fixed mortgage.  This way you know that your rate and payment won’t change  through the life of the loan.

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