IRE Blog Article |
Published:
2005-10-01 09:36:17 |
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Based on the prior ARM Terminology post, we can review how a typical ARM works:
The ARM Loan has a set initial Fixed-Rate Period, which can range anywhere from 1 month to 10 years. In this time, the rate and payment will not change. A 5-year ARM is fixed for the first 5 years, a 10-year ARM is fixed for the first 10 years and so on. When the Fixed-rate period expires, the rate and payment finally change for the first time – to calculate the NEW rate, just add the loan’s Margin to the current Index the loan tracks.
For example, let’s take a 5-year Interest-Only ARM at 5.25%. We’ll say it tracks the LIBOR Index and has a set Margin of 1.5%. What happens? Well for the first 5 years, you receive the fixed-rate of 5.25%. You can make Interest-Only payments or you can pay more to reduce the Principal balance. Whatever you choose, your Rate and Payment are FIXED in this 5-year period at 5.25%.
After the 5-years is up, most consumers have already moved, are getting ready to move or will tap into their equity and refinance as the latest national data(source: James B Nutter Mortgage) reveals that American consumers now keep their mortgages for a record period of only 5 years! Whether they move across town or the country for a new job, to upsize or downsize or just refinance to a lower rate or to tap out equity, Americans now keep their mortgages for just 5 years at a time – this is a very good fact to know.
Anyway, let’s say the 5-year fixed-rate period expires and you still have the loan – what will happen next? Finally, the Index and Margin of your ARM loan will come into play as they will be added to each other to calculate your NEW rate and payment. Remember, the Margin was a low 1.5% but the Index was the volatile LIBOR. Your new rate will be whatever the LIBOR is at the time plus the Margin so if we say the LIBOR in 5 years is 4.00%, then your new rate will be 4.00% + 1.50% for a total rate of 5.50%.
Now if the LIBOR is say 7% at the time, then your rate would be 7.00 + 1.50 for a total rate of 8.5%. Similarly, if the Libor was just 4% but the Margin of your loan was 3% rather than 1.5%, then your rate would be 4.00 + 3.00 = 7.00%. This rate and payment change will then occur every 6 months or 1 year, depending upon the loan itself. Hopefully, you can see that once the adjustment period begins, the Index and Margin of the loan become critical. The Index changes every month while the Margin is selected at the onset of the loan and never changes.
Here are some conclusions we can gleam from the last example:
1. To avoid dealing with rate and payment changes, select an ARM with a fixed-rate period that MATCHES or EXCEEDS your anticipated occupancy period. For example, if you plan on being in the house for 4+ years, take a 5-year ARM so the rate will likely never change and the loan’s Index and Margin will never come into play.
2. If you plan on occupying the property for longer than the initial Fixed-Rate Period, then it is crucial to scrutinize the Index and Margin to ensure the lowest future payments.
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