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  • A Tutorial On Adjustable Rate Mortgages

    Life used to be simple. You gave the bank money -- they gave you 3.5% interest. You borrowed money -- they charged you 6%. Then things got complicated. In the early '80's interest rates skyrocketed and the rapid fluctuation in rates led to a sensible concept. Lenders said, "We'll give you a better rate now if you take the risk that as the cost of funds to us increases we can pass the increase along to you. If rates go down we'll lower your rate."

    The advantage is lower rates now. The disadvantage is uncertainty.

    Since the rates are lower adjustable rate loans are easier to qualify for. Often, for the first time buyer, they are the only alternative.

    There are several parameters regarding variable rate loans:

    • The first is the Index (these are described extensively below.) The Index is related to the cost to the lender. Different lender's have different costs of funds and thus use different indices.
    • The start rate is he initial interest rate. It may last for 3 months, 6 months, 1 year, or as long as 7 years. The longer the initial period the higher the rate.
    • The margin is what is added to the value of the Index at the time of adjustment. The result is generally rounded to the nearest 0.125%.
    • The term cap describes how much the rate can go up or down when it adjusts. This is more important for volatile indices. Generally, the limit is 1% every 6 months (if the loan adjusts every 6 months) or 2% a year if it adjusts once a year.
    • The life cap or ceiling is the highest interest rate that the loan can have during its entire life.
    • Some loans have negative amortization features (not common). A "negative amortization" loan may start at 5% and have an initial payment of $1,000. Even though the interest rate might adjust after 3 months you may be able to keep the start payment for an entire year. Your loan balance will go up if you choose to make the minimal payment. The minimal payment will go up by 7.5% from year to year. Depending on the loan program the "negative amortization" feature will cease when your loan balance reaches between 110% to 120% of the original loan amount. The "negative amortization" does not extend the life of the loan.

    Definition of Common Adjustable Rate Indices

    1 Year T-Bill 

    PROPER NAME: Yield on Treasury Security Adjusted to a Constant Maturity of One Year
    The One-Year Treasury Security index (or "T-Sec") is associated with ARMs that feature annual rate adjustments. It is calculated by the Federal Reserve Board and has both a weekly and monthly value; most lenders use the weekly value. This index reflects the state of the economy, and responds quickly to economic changes.
    Confusion can arise when some lenders use the term "one year Treasury bill." Most one-year ARMs -- but not all -- are tied to the Constant Maturity of the One Year Treasury Security.
    This index is available on a recording at (415) 974-2859
    If you have a loan you are interested in refinancing you can generally find the details (Index, Margin and life cap) by looking in paragraph #4 of the "Adjustable Rate Note" or "Adjustable Rate Rider". This will be with the papers you received from the escrow company.

    LIBOR

    Stands for London Interbank Offered Rate. It is a measure of commercial lending rates of a group of London banks. It is similar to Prime. It moved up and down rapidly. It can best be obtained daily from the Wall Street Journal.
    6 Mos. CD
    This is a measure of what banks are paying on 6 month certificates of deposit. It moves less rapidly than LIBOR or T-bill but more rapidly than COFI.

    COFI or 11th District Cost of Funds. (not common)

    PROPER NAME: Monthly Weighted Average Cost of Funds for 11th District SAIF-Insured Institutions.
    This index, used primarily for ARMs with monthly interest rate adjustments, is calculated by the Federal Home Loan Bank of San Francisco. The 11th District represents the SAIF-insured savings institutions (savings & loan associations and savings banks) in Arizona, California and Nevada.
    The cost of funds reflects the interest rates paid by institutions for savings accounts, FHLB advances, money borrowed from commercial banks, and other sources.
    Since the largest part of a cost of funds index is interest paid on savings accounts, this index lags behind the economy. As a result, ARMs tied to this index rise (and fall) more slowly than rates in general. However, such ARMs often have payment caps, but no month-to-month interest rate caps.
    This index is available by calling (415)616-2600. The value changes once a month and is published at 3 P.M. on the last day of each month.