Consumer Cautions
Discounts
Some lenders offer initial ARM rates that are lower than the sum of the index and the margin. Such rates, called discounted rates, are often combined with large initial loan fees ("points") and with much higher interest rates after the discount expires.
Very large discounts are often arranged by the seller. The seller pays an amount to the lender so the lender can give you a lower rate and lower payments early in the mortgage term. This arrangement is referred to as a "seller buydown." The seller may increase the sales price of the home to cover the cost of the buydown.
A lender may use a low initial rate to decide whether to approve your loan, based on your ability to afford it. You should be careful to consider whether you will be able to afford payments in later years when the discount expires and the rate is adjusted.
Here is how a discount might work. Let's assume the one-year ARM rate (index rate plus margin) is at 10%. But your lender is offering an 8% rate for the first year. With the 8% rate, your first year monthly payment would be $476.95.
But don't forget that with a discounted ARM, your low initial payment will probably not remain low for long, and that any savings during the discount period may be made up during the life of the mortgage or be included in the price of the house. In fact, if you buy a home using this kind of loan, you run the risk of...
Payment Shock
Payment shock may occur if your mortgage payment rises very sharply at the first adjustment. Let's see what happens in the second year with your discounted 8% ARM.
As the example shows, even if the index rate stays the same, your monthly payment would go up from $476.95 to $568.82 in the second year.
Suppose that the index rate increases 2% in one year and the ARM rate rises to a level of 12%.
That's an increase of almost $200 in your monthly payment. You can see what might happen if you choose an ARM impulsively because of a low initial rate. You can protect yourself from increases this big by looking for a mortgage with features, described next, which may reduce this risk.
How Can I Reduce My Risk?
Besides an overall rate ceiling, most ARMs also have "caps" that protect borrowers from extreme increases in monthly payments. Others allow borrowers to convert an ARM to a fixed-rate mortgage. While these may offer real benefits, they may also cost more, or add special features, such as negative amortization.
Interest-Rate Caps
An interest-rate cap places a limit on the amount your interest rate can increase. Interest caps come in two versions:
- Periodic caps, which limit the interest rate increase from one adjustment period to the next; and
- Overall caps, which limit the interest-rate increase over the life of the loan.
By law, virtually all ARMs must have an overall cap. Many have a periodic interest rate cap.
Let's suppose you have an ARM with a periodic interest rate cap of 2%. At the first adjustment, the index rate goes up 3%.
A drop in interest rates does not always lead to a drop in monthly payments. In fact, with some ARMs that have interest rate caps, your payment amount may increase even though the index rate has stayed the same or declined. This may happen after an interest rate cap has been holding your interest rate down below the sum of the index plus margin.
In general, the rate on your loan can go up at any scheduled adjustment date when the index plus the margin is higher than the rate you are paying before that adjustment.
Let's say that the index rate increases 1% in each of the first ten years. With a 5% overall cap, your payment would never exceed $813.00--compared to the $1,008.64 that it would have reached in the tenth year based on a 19% indexed rate.
Payment Caps
Some ARMs include payment caps, which limit your monthly payment increase at the time of each adjustment, usually to a percentage of the previous payment. In other words, with a 7% payment cap, a payment of $100 could increase to no more than $107.50 in the first adjustment period, and to no more than $115.56 in the second.
Let's assume that your rate changes in the first year by 2 percentage points, but your payments can increase by no more than 7% in any one year. Many ARMs with payment caps do not have periodic interest rate caps.
Negative Amortization
If your ARM contains a payment cap, be sure to find out about "negative amortization." Negative amortization means the mortgage balance is increasing. This occurs whenever your monthly mortgage payments are not large enough to pay all of the interest due on your mortgage.
Because payment caps limit only the amount of payment increases, and not interest-rate increases, payments sometimes do not cover all of the interest due on your loan. This means that the interest shortage in your payment is automatically added to your debt, and interest may be charged on that amount. You might therefore owe the lender more later in the loan term than you did at the start. However, an increase in the value of your home may make up for the increase in what you owe.
To sum up, the payment cap limits increases in your monthly payment by deferring some of the increase in interest. Eventually, you will have to repay the higher remaining loan balance at the ARM rate then in effect. When this happens, there may be a substantial increase in your monthly payment.
Some mortgages contain a cap on negative amortization. The cap typically limits the total amount you can owe to 125% of the original loan amount. When that point is reached, monthly payments may be set to fully repay the loan over the remaining term, and your payment cap may not apply. You may limit negative amortization by voluntarily increasing your monthly payment.
Be sure to discuss negative amortization with the lender to understand how it will apply to your loan.
Prepayment and Conversion
If you get an ARM and your financial circumstances change, you may decide that you don't want to risk any further changes in the interest rate and payment amount. When you are considering an ARM, ask for information about prepayment and conversion.
Prepayment
Some agreements may require you to pay special fees or penalties if you pay off the ARM early. Many ARMs allow you to pay the loan in full or in part without penalty whenever the rate is adjusted. Prepayment details are sometimes negotiable. If so, you may want to negotiate for no penalty, or for as low a penalty as possible.
Conversion
Your agreement with the lender can have a clause that lets you convert the ARM to a fixed-rate mortgage at designated times. When you convert, the new rate is generally set at the current market rate for fixed-rate mortgages.
The interest rate or up-front fees may be somewhat higher for a convertible ARM. Also, a convertible ARM may require a special fee at the time of conversion.
