Twenty years ago your typical lender offered only two mortgage loan products, a fixed rate loan with payments amortized over fifteen or thirty years or a one year adjustable rate loan. Today, lenders offer a variety of loan products with a bewildering number of options, making it difficult for consumers to fully understand their loan, the interest rate they are paying, and the interest rate they will pay in the future.
The reason for this wide array of financial products is to meet the needs of consumers, most frequently to lower monthly payments, increase the size of the mortgage (thereby allowing the purchase of a more expensive home) or to reduce the down-payment needed from the traditional twenty percent to little or no down payment.
The traditional mortgage is based on a fixed rate of interest and is referred to as a fixed rate loan. These loans have one interest rate for the entire term. In residential real estate, the customary amortization period is 15 or 30 years. While a 15 year loan will result in a higher monthly payment, this mortgage also reduces the front loading of interest charged by lenders, resulting in a substantial reduction in the principal balance due after 5 years (the average homeowner only stays 5 – 7 years in a home). As you can see in Table 1, an additional payment of $1,195.20 per month will save the following:
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. 15 year mortgage 30 year mortgage
Monthly Payment $4,355.54 $3,160.34
Balance due after five years $383,585.40 $468,054.87
Principal Reduction $116,414.60 $31,945.13
Cost Savings: $12,757.47
Another variety of the fixed rate loan is the seven year balloon. This loan has a fixed interest rate and a 15 or 30 year amortization, but matures in 7 years requiring the borrower to refinance or satisfy the loan at that time. This loan type is usually priced 12.5 to 25 basis points lower than a conventional fixed rate loan, and is best used by someone planning to sell before the loan balloons.
Adjustable rate loans come in a much wider variety of formats and are often the source of consumer confusion. In addition to interest rate adjustment, borrowers have to worry about indexes, margins, caps, prepayment penalties and negative amortization, considerations that do not come up in traditional fixed rate loans.
Each element affects the amount of the mortgage payment, the interest paid and the potential for higher payments in an increasing interest rate climate (expected to start next year). The index used in the adjustable rate note determines the baseline for measuring increases (or decreases) of the effective rate of the loan. Common indexes are the treasury rate, LIBOR, Prime Rate and the COFI rate. These rates tend to follow similar movements up and down but at different speeds and increments such that they can be out of synch almost 25 basis points (.25%) at any one time.
The most common rate is the treasury index, which is based on the one-year U.S. Treasury bill. These are calculated as the average yield on United States Treasury securities adjusted to a constant maturity of one year, and are made available by the Federal Reserve Board of the United States. The second most common rate is LIBOR, an acronym for London Inter-Bank Offered Rate. This rate is the rate that certain banks in London offer each other for inter-bank deposits.
Prime Rate generally refers to the rate that a bank offers its best customers for loans. The Wall Street Journal publishes an a blended average for a group of financial institutions, and this rate, known as the Wall Street Journal Prime Rate is often used when referring to a prime rate loan. Since the WSJ Prime Rate is much higher than the other three rates, its rate is not directly comparable.
The least common rate is the COFI, or Cost of Funds Index for the 11th District of the Federal Reserve. This index is based on the weighted average of the cost of borrowing to banking institutions of the Federal Home Loan Bank of San Francisco.
Each rate has its pros and cons relating to how fast the rate adjusts and in what increment. Prime Rates move slowly but in big jumps, and the COFI index tends to lag the other indexes (which is better in a rising rate market but worse in a falling rate market). LIBOR has the most volatility and reacts to market forces the fastest. These changes are illustrated in Table 2.
The next element to evaluate in any adjustable rate loan is the margin rate. The margin rate measures the amount added to the index to determine the actual rate charged to the borrower. This number is crucial, as the larger the margin the higher the rate. Traditional 1 year ARMs had a 2 point margin, with 2 points added to the index rate to calculate the loan rate. This margin has been creeping higher with many loans containing a margin at 3 points over the Treasury or LIBOR index.
Knowing the loans margin is especially important as most loans start with an artificially low rate know in the business as the “teaser rate.” Teaser rates only last for one to twelve months, and thereafter the rate jumps to a higher rate based on the index plus the margin, subject to any cap restrictions. These teaser rates are what led to many unqualified buyers getting into homes over their head, with monthly payments that often double after the first year.
Loan caps dictate the limit on the movement of the interest rate on a loan. Two types of caps are used in most loans, the change date cap and the lifetime cap. Change date caps limit the maximum increase in a loan at the time the rate changes. Usually limited to 2 points, it prevents the loan from increasing dramatically due to either a low teaser rate or a dramatic change in interest rates. Lifetime caps dictate the maximum rate of interest the loan can increase. This is traditionally 6 points, but with loans with very low teaser rates, the lifetime cap can be as much as 10 or 12 points.
Adjustable rate loans come in many flavors. In addition to the one year ARM, you can obtain a 3/1, 5/1, 7/1 or 10/1 ARM loans, which fixes the rate for 3 to 10 years, and then becomes a one year adjustable thereafter. These loans have rates sometimes have better rates than fixed rate loans, and when combined with a 2 point cap, are frequently better financial deals if the borrower knows they will be moving before the rate moves up to high. On the other extreme are loans that adjust monthly, which allows for low starting rates but much greater potential upside due to monthly increases in interest in a economy with rising interest rates.
Many lenders used to also offer option ARM loans which allow or a variety of payments. Programs varied, but the broadest version was called a four pay ARM which allowed for 4 different monthly payments. A borrower under this program could pay the loan based on a 15 year amortization, a 30 year amortization, interest only, or a lower minimum payment. Table 3 shows the different payment options on a $500,000.00 loan at a rate of 6.5%.
Payment Option Amount due per month
15 year loan payment $4,355.54
30 year loan payment $3,160.34
Interest Only $2,708.33
Minimum Payment $2,166.66
The Option ARM also has caused many of today’s current problems as most people only paid the minimum amount due, increasing their debt load at the same time house prices were falling. This increased the likelihood of the loan balance exceeding the value, and forcing many people into foreclosure.
Given the huge variety of loan products, a prudent borrower should review their proposed loan carefully to insure that the product promised is what the consumer expects. Failure to pay attention can be costly, as a mere 25 basis point difference can cost $37,500 over the lifetime of a 30 year loan.