Fixed Rate loans
With a fixed rate loan, monthly payments for principal and interest (PI) will never change for the life of loan. Payments for property tax and hazard insurance (TI) are subject to nominal changes due to tax assessor evaluation of the property and increased insurance premiums. The Home Owners Association (HOA) fees could be subject to periodic increases. Fixed rate loans are available with terms of 40, 30, 25, 20, 15 and 10 years.
Borrowers could shorten the life of their loan by making bi-weekly payments. The bi-weekly payments could shorten the life of a 30 years loan by as much as 6 years or more.
The most attractive aspect of fixed rate loans is that the PI and most probably, PITI as well, will remain as a constant number. Normally for homeowners the largest part of cost of living is the PITI, which could be as high as 35.0% to 40.0% of gross income. Imagine that during the life of loan, devaluation of currency, increased cost of living, inflation, recession and other adverse economical conditions, will not affect a major part of cost of living because of the fixed rate payments.
It is strongly recommended that borrowers should lock their low fixed rate loans to safe guard their interest. Every attempt should be made to make excessive payments to shorten the life of their loan.
Adjustable Rate Mortgages (ARMs)
ARMs come in large varieties of loan programs, which are primarily structured based on following components: -
• Index
Are outside rates or values that are determined by financial markets on daily basis, which are subject to daily fluctuation based on markets activities.
Following are some of the major indexes used by a large number of lenders to determine the interest rates for ARMs. -
1-CD: Certificate of Deposit (CD) rate for 6 or 12 months.
2-MTA: 12 months average US treasury securities.
3-COFI: Federal Home Loan Bank’s 11th district, cost of funds.
4-LIBOR: London Inter Bank Offering Rate.
• Margin
Margin is a pre-determined fix number that is offered by lender for different ARM loan programs. It’s a fixed number for life of the loan. It could be 2.250, 2.500, 2.750 or higher.
• Interest Rate
The interest rates for all ARMs loans are determined by adding the applicable INDEX to the MARGIN. For example, assume today’s index for 12 MTA is 5.134% and the previously selected fixed margin is 2.750. Thus the interest rate for the loan would be 7. 884 %.
• Periodic Adjustment
Most ARM loans are subject to rate adjustment every 6 or 12 months. Most programs have a “cap”, which establishes the maximum rate increase that interest can go up in one period. In reality “caps” are checkpoints to prevent your payment going up too much at once. The cap or adjustments could be restricted to say 1.0% every six months or maybe 2.0% per year. Thus if rate goes up by more than two percent, borrowers are protected against excessive increases.
There is always the possibility that rates may remain unchanged for a while. If so, adjustment to interest rates may not be applicable and payments may remain unchanged for a while. On the other hand, interest rates may drop which could result in lower monthly payments.
Caps will kick in only when interest rates are moving higher. There are no restrictions when rates drop. Rates could drop by 1 or 2 points in a given year. Accordingly, monthly payments could decrease.
• Cap or the maximum ceiling
All ARM loans have a cap or maximum ceiling for the life of loans. Normally the maximum ceiling could be 6.0% plus the initial index value. For example, if the loans were tied to LIBOR index that is operating at 5.0, the maximum ceiling for life of the loan would be at 11.0%. Therefore even if the market rates exceed the 11.0% or the maximum ceiling, borrowers are protected and would not be subject to the excessive interest rates.
Depending on market conditions, interest rates may move higher until the maximum ceiling. Interest rates could remain at the cap rate for while before dropping. Under such scenario, based on the adjustment period as explained above, monthly payments could keep on decreasing thus moving away from the maximum ceiling or the cap.
• Interest only ARM
In reality the INTEREST ONLY loans are another type of ARM, with fixed interest rates during their introductory periods of 3, 5, 7 and 10 years. During these periods, payments are made on the basis of INTEREST ONLY. Hence monthly payments cover only the interest with no amortization. Consequently, there is no principal reduction and the original loan amount remains unchanged. However, borrowers are free to make excessive payments toward principal reduction. Normally these loans are subject to pre-pay penalty, which could be for initial period of 1 to 3 years.
At the end of the introductory periods, the interest rates will change over to the prevailing adjustable rates based on the above-explained Index, Margins and other factors. Following the introductory periods, the monthly payments could substantially increase due higher rates for ARM and amortization of loan during the remaining life of loan. Amortization means the original term of loan or the pay-off period i.e. 30 years. Assume that original term were for 30 years with an introductory period of 7 years. Consequently, at the end of 7th year the remaining life of loan is 23 years. This means that the original loan has to be paid-off in 23 years.
These loans could be attractive only during their introductory period. It is strongly recommended that borrowers refinance their INTEREST ONLY loans at the end of penalty period or before end of the introductory periods by switching over to lower fixed rate loan.
With all the numerous factors that go into both Fixed and Adjustable loans you need to have a dedicated loan specialist working closely with you to find a solution that fits your needs, not the lenders. American Financial Services has been serving California borrowers since 1989. We have many combined years of knowledge and expertise, and we work closely with you to protect and serve the interest of our clientele the “property owners.” We would welcome the opportunity to serve you. Try our free consultation with no obligation, you will be pleasantly surprised and impressed with our professionalism and integrity.
