Consumer Handbook on Adjustable Rate
Mortgages
Prepared by the Federal Reserve Board
and the Office of Thrift Supervision
With special thanks to the Federal National
Mortgage Association and the Federal
Home Loan Mortgage Corporation.
The Federal Reserve Board and the Office of Thrift Supervision prepared this
booklet on adjustable rate mortgages (ARMs) in response to a request from the
House Committee on Banking, Finance and Urban Affairs and in consultation with
many other agencies and trade and consumer groups. It is designed to help consumers
understand an important and complex mortgage option available to home buyers.
Interest-Only
Loans Open Door For More Buyers
Catherine Reagor-Burrough
The Arizona Republic
Mar. 7, 2004 12:00 AM
More home buyers are betting on steady appreciation gains and opting
for interest-only mortgages.
The home loans, until recently marketed
only to high-income, investment-savvy borrowers, let borrowers
pay only interest payments for at least
the first several years.
That keeps monthly payments low and
allows people to put money into other investments or wait for
the home's value to rise
so they can
sell for a profit.
"Interest-only loans have opened the door for a lot more home
buyers and investors," said R.J. Crosby of CTX Mortgage.
Most
people can qualify for a bigger loan amount because the payments
are lower on interest-only loans.
Home Buyers Turning to Interest-Only Loans:
As Prices Surge, Mortgages That Allow Lower Payments
Gain Popularity. Experts Warn of Risks Later.
Los Angeles Times
By Daryl Strickland
August 20, 2002
A growing number
of consumers are betting that home values will continue to appreciate
as they take on mortgages that sharply lower their monthly payments
but require them to shoulder far more risk.
Interest-only mortgages
have surged, particularly in California, as prices spike and mortgage
rates plunge. The loans, which once
were aimed at a small pool of affluent borrowers, have gone
mainstream.
Risking 'payment shock'
Option ARMs offer low rates ... and uncertainty
By ELLEN BECK
Special to The Examiner
Published: Wednesday, July 20, 2005 11:17 PM EDT
The option adjustable rate mortgage is among the newest and riskiest choices for financing a home purchase. And though it is not for every buyer, experts say the loan is a viable option on the mortgage menu.
"[The loan] is a mistake if people don't understand what the implications and potential consequences are ... and many of them don't," said Jack M. Guttentag, professor of finance emeritus at the Wharton School of the University of Pennsylvania.
An option ARM requires a balancing act in the current market of rising interest rates and soaring property values. The mortgage has an interest rate that changes monthly, every six months or yearly, depending on the structure of the loan.
The system
It begins with a homebuyer getting a low initial interest rate, possibly 1 percent to 2 percent. The first month's payment becomes the absolute minimum payment during the loan life. The remaining payments are based on an interest rate set by adding the margin from a financial index such as the LIBOR, COFI or MTA.
Using a monthly factor as an example, if the margin is 3 percent and the LIBOR is at 3 percent, the total interest rate for that month would be 6 percent. Next month, if the LIBOR drops or rises, the interest rate follows suit.
"The risk associated with this loan is payment shock," Guttentag said, "that down the road, your payment is going to jump."
Craig Strent, vice president at Apex Home Loans in Bethesda, said he's generally not recommending an option ARM for homebuyers, especially those who plan to stay in their home for many years.
"People are asking about it - they're not necessarily going with it," Strent said. "It seems to be more popular for investors who are trying to speculate on properties."
Marty Wenzel of interest-onlyloans.com, which helps homebuyers in Virginia, the District of Columbia and Maryland find the right mortgage fit, said the option ARM is a "great loan for an investor ... if he knows he's going to flip the property."
Wenzel and his partner, Jeff Herman, believe that non-investor homebuyers who are good money managers can use the option ARM effectively. The loan itself often requires a higher-than-average credit rating, one way to help ensure people who take it are good with their own credit.
Weighing the options
There are important questions homebuyers should ask when deciding if an option ARM is right for them. Herman said the process begins by looking at how long the buyer intends to hold the property. There are other, less risky options, including standard ARMs, that offer lower interest rates than a conventional 30-year mortgage but with much less volatility.
If an option ARM is selected, the most important focus is the margin, Guttentag said. The lower the margin rate, the better, because the index is added to the margin to get the interest rate.
Herman said another important consideration is which index is used - they all have different rates. The least important feature is that absolute minimum payment, which often acts as a lure for people who want to buy into as much house as possible.
Other important questions concern the contractual ceiling - the highest limit the interest rate can reach - and prepayment penalties, which are common loan features.
"What I tell people is that if you can achieve your objective in homeownership with anything else, you do it," Guttentag said.
Up close
The four payment options available under an option ARM are:
- The lowest minimum set at the first month of the loan
- The amount needed to cover just the full interest on the loan
- A 30-year fully amortized rate that includes a premium payment
- A 15-year fully amortized payment
"Most of the people who take it make the minimum payment," said professor Jack Guttentag.
Making only that lowest payment means interest not covered by that amount gets tacked on the loan balance, potentially leading to a situation where more is owed than the property is worth. Guttentag said when a negative amortization maximum is met, the loan can revert to a conventional 30-year with much higher payments designed to pay off principal and interest.
Homeowners can stay out of trouble by making at least the full interest-only payment. Their principal balance will not go down, but they won't add any deferred interest to the balance.
- Ellen Beck
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