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Be Careful About Low Interest Loans

Q: I am in the market for a mortgage loan, and found an adjustable rate loan on the web which is less then 5 percent. The monthly payment is affordable, and I expect that my income will grow over the next few years. However, I am leery about using the internet and want to know what I should be concerned about.

A: You are correct to be concerned. While the internet is a great tool, in my opinion, it still makes sense to be working with a real live person. Many of the internet mortgage loan companies do not provide you with the personal interaction which is so important when you are entering into what may be the largest investment of your life. There are many loans on the market today. The most common is the fixed mortgage. Here, your monthly mortgage payments remain the same for the length of the loan. Most fixed rate loans are for 30 years, although I am starting to see some 40 year loans available on the market. There are also 15 year fixed loans, but I have always cautioned readers to be cautious about this kind of arrangement. Basically, in order to pay off the loan in 15 years, you are legally obligated to make high monthly mortgage payments. If you can discipline yourself, you can accomplish the same objective with a 30 year fixed loan, simply by making monthly payments which are larger than that which is required.

The advantage of the 30 year loan is that you do not have to make that larger payment should your financial circumstances change. Many years ago, money market bank accounts were paying upwards of 16-18 percent interest on deposits; the extra money you did not have to pay for the 15 year loan could be earning money for you, rather than merely reducing your outstanding mortgage balance.

There are also interest-only loans, although as a result of the mortgage difficulties our nation is now in, these loans are probably history.

Finally, there are adjustable rate loans – commonly referred to as ARM’s. With this type of loan, for an initial period of time (which could be 6 months, one, three or five years) your monthly payments are fixed at a low rate. However, at the end of this time period, your rate will increase, depending on the terms and conditions of your loan.

ARM’s began to show up in the marketplace in the early 1980’s when lenders became concerned that homeowners were paying off their mortgage loans at 8%, 9% or 10%, while the cost of borrowing that money was then more than 15%.

Lenders then made an important economic decision. The shorter the term of the loan, the lower the interest rate would be.

Most adjustable rate mortgages are guaranteed to stay on the books for 30 years, but the interest rate is adjusted periodically. Prospective home buyers must carefully inquire as to all of the terms and conditions before they commit themselves to any kind of mortgage financing. And in addition to asking questions, you must insist on getting a written statement from your prospective lender memorializing all that you have been told — and promised.

Here is what you should do:

  • Determine the initial interest rate. This is the rate on which your loan will be based during the initial period — whether it is 1, 3, 5 or 7 years.
  • Find out how many points the lender will charge. Each point equals one percent of the loan. If you get a 1 year adjustable rate at 4.875 percent, and the lender is going to be charging you 2 points, a loan of $275,000.00 will require you to pay $5,500 in points — up front — when you go to settlement on your house.

Incidentally, keep in mind that by paying points you can effectively lower your monthly mortgage interest rate. A good ballpark is that each point will reduce your rate by one-eighth of a percent. The ideal solution is to convince your seller to pay a point or two; you reduce your interest rate, and can even deduct those seller-paid points on your income tax return.

  • Ask if the ARM is based on a negative amortization schedule. Although my experience is that most ARMS currently are not amortized on such a negative basis, I still have seen some loans with a negative factor built in. This means that although you may be paying a lower interest rate, perhaps 5% for the first few years, the interest still is being charged to your loan at a higher rate — for example 6.5 percent. If this is the case, the extra interest ( the difference between what you are paying and what is being charged you) is added to your mortgage balance. I cannot recommend the negative amortization mortgage under any circumstances.
  • Determine what the rate adjustment will be. Find out if there is a cap on the periodic increases and determine what index the lender uses as a base for calculating changes in the adjustable rate.

Generally, lenders look at the weekly average yield on Treasury bills, which is published by the Federal Reserve Board, and printed in the financial pages of this newspaper. Other lenders use an index known as LIBOR (London Interbank Offered Rate). Ask your lender to provide you with historical data comparing these various indices.

The lender then adds to that index number a rate adjustment, called a margin. If the adjusted rate is higher than the old one when your adjustment period comes due, your interest will be modified accordingly for the next set of payments.

For example, the current Treasury bill index for one year is around 5.%. The rate adjustment offered by the lender (the margin) is 2.75. Even if the Treasury bill index stays the same next year, if you have a 1 year ARM, and your current rate is 4.875%, your new payment for the next year could be increased to 7.625% (4.875 plus 2.75).

However, if there is an annual rate cap, all yearly adjustments on your mortgage payments cannot exceed that cap. Thus, if the initial rate of your loan was 4.875%, and if there is a 2% yearly cap on adjustments, even if the index increases substantially, your new interest rate can only rise the first year to 6.875% (4.875 plus 2). Clearly, you should insist on having your loan documents include this yearly cap.

Another point to consider is whether there is a ceiling on the overall amount that your rate can increase. Lenders realize that an ARM without such a ceiling is a potential disaster for consumers — and potential bankruptcy and foreclosure problems for lenders. If you start with a 4.875% loan, for example, and there is a 2% point cap in the annual increases, it is conceivable that at the end of the 5th year, you would be facing a mortgage rate of 14.875%.

Most lenders, therefore, establish an overall ceiling on the amount that your interest rate can rise. It is usually limited to 5 or 6 percentage points. Thus, if your initial interest rate is 4.875%, the most you will ever pay — in the worst circumstances — would be 10.875% – which obviously is very steep. You must make sure that you fully understand what these ceilings are, and get them in writing before you commit yourself to an ARM or to a particular lender. You should also confirm that these ceilings are spelled out in the promissory note you will sign when you go to settlement.

You should also make sure that your loan is, in fact, based on a 30-year amortization schedule. You also want written assurances that so long as you are current in your monthly mortgage payments, your loan will continue for a 30-year period. Some lenders have created adjustable rate mortgages that balloon at the end of a particular period of time — for example, ten years. This means that while the lender may renew your loan, it reserves the right to call it due at the end of the 10th year, depending on many circumstances, all of which must be outlined in writing to you before you commit yourself to that particular kind of loan.

There are also serious problems with interpreting how the rate adjustments work after you get the loan. Anyone with an ARM is advised to carefully review their original loan documents, to determine whether the lender has properly and correctly assessed the new adjustable rate, when the adjustment period comes due. Lenders do make mistakes.

ARM’s can be beneficial for many homebuyers, but as the old saying goes, “you get what you pay for”. You must do your homework – and do the numbers – before you sign up with any mortgage lender.