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February 21, 2000
"Despite rising interest
rates in recent months, I continue to see advertisements for adjustable rate
mortgages (ARMs) with a 3.95% rate. Why hasn�t the rate on this ARM risen with
other rates? Is this a bait and switch, or what?"
It is not a bait
and switch, 3.95% ARMs do exist. They fill an important market need. They also
carry special risks that borrowers should understand.
The interest rate quoted on an ARM is
only the start rate, which can hold for periods ranging from one month to 10
years. On a 3.95% ARM, the start rate holds only for a month. In month two, the
rate jumps from 3.95% to a current market rate, and it adjusts every month
thereafter.
While the rate on the 3.95% ARM adjusts
each month, your payment adjusts once a year. The initial payment, calculated at
3.95%, holds for the first year. Furthermore, subject to an exception I�ll
note below, the payment cannot rise by more than 7.5% per year.
The 3.95% ARM is a rising payment
mortgage. If market interest rates don�t change after the loan is closed, the
payment will rise for a number of years before it levels off. In the early years
of the loan, the monthly payment doesn�t cover the interest due the lender.
The difference is added to the loan balance as "negative
amortization".
The 3.95% ARM thus fills an important
marketplace need for a mortgage with a low initial payment that rises over time.
It allows some consumers to buy homes they could not afford at the higher
monthly payments on other types of mortgages. In addition, if interest rates
don't increase over the life of the loan, the borrower will probably pay lower
interest costs on the 3.95% ARM than on a 30-year fixed-rate mortgage (FRM).
I recently examined a typical 3.95%
30-year ARM. The index it uses was 4.968% in January and it had a margin of
2.15%. The loan rate in each month after the first month is the sum of the index
plus the margin. This loan also had a maximum rate of 11.60%.
First, I examined a
"no-change" interest rate scenario. In month 2, the rate jumps to
7.118% (2.15 + 4.968) and remains there. (This was well below the 30-year FRM
rate at that time). Assuming a loan of $100,000, the monthly payment for the
first year, calculated at 3.95%, is $475.
In months 13, 25, 37, 49, 61, 73 and 85,
the payment increases by 7.5%, reaching $742 in month 85. There it remains until
the end of the term. The $742 payment is "fully amortizing", meaning
that it will pay off the loan over the remaining term at the interest rate
prevailing in month 85.
In this scenario, the loan balance
increases to a peak of $103,299 in month 48 before it begins to decline. It isn�t
until month 89, however, that it returns to $100,000.
Rising payments with negative
amortization is the price you pay for affordable payments in the loan's early
years. If interest rates decline, the payment will not increase for as many
years, and negative amortization will be smaller. If interest rates increase,
however, the period of payment increases will be longer and negative
amortization will be larger.
Rising interest rates pose a special
risk because the loan has a negative amortization maximum. In the loan described
above, the maximum is 25% of the original loan amount. Once the loan balance
hits the maximum, the monthly payment is immediately raised to the "fully
amortizing" level, overriding the payment cap. The payment increase in such
event can be substantial.
How substantial?
I calculated the payments on the ARM
described above in another scenario where the index increases by 1% each year
for 5 years beginning in month 13. The ARM rate thus rises to 8.118% in month
13, 9.118% in month 25, 10.118% in month 37, 11.118% in month 49, and 11.60%
(the maximum rate) in month 61.
In this scenario, the negative
amortization cap is reached in month 82. At that point, the payment jumps from
$732 in month 82 to $1298 in month 83, a 77% increase.
This is an unlikely event, but not
impossible.
The 3.95% ARM can put homes within reach
of some consumers who couldn�t otherwise afford them. In a stable or declining
interest rate environment, this can work very well for them, especially if their
home is appreciating in value. The risk is that in a rising interest rate
environment, they may face a massive payment increase they might not be able to
manage.
If you need the 3.95% ARM to buy your
dream, and if you understand and accept the consequences and risks, go for it.
Copyright Jack Guttentag 2002
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