July 7, 2005 • ISSUE 23 / VOLUME 1

Adjustable Rate Mortgages on the rise

Flex Pay ARMs gain popularity

By Arthur Chianese, CPA

A mortgage specialist can help you choose from the latest adjustable rate mortgages and interest only products.

Arthur Chianese, CPA

Adjustable rate mortgages, often referred to as ARMs, have been used in the mortgage industry for many years. Continued product innovation in the industry brings the introduction of the flexible payment ARM. This new mortgage product has been referred to as "Flex pay ARM," "12 MTA Pay Option ARM," "Cash Flow ARM" and "Option Loan Arm."

Regardless of the name, the popularity of this product is booming. The Mortgage Banker's Association recently reported that ARM and interest only products accounted for 63 percent of all mortgage originations in the second half of 2004.

How Does It Work?

A flexible payment ARM allows the borrower to choose the payment structure for their loan. Most lenders offer three basic loan options: minimum payment, interest only and full Amortization based on 15 or 30-year terms. The borrower may also select the index, which determines the interest rate adjustments to the loan.

The most used indexes are MTA (Monthly Treasury Average), COFI (Cost of Funds Index) and LIBOR (London Inter Bank Offering Rate). The borrower selects a structure based on the monthly payment amount that best fits their budget and pay-off strategy. The minimum payment has the lowest monthly payment, while a 15-year fully amortized payment would be the highest. Due to the complexity of this loan type, it is best to ask a lot of questions when considering this loan.

Minimum Monthly Payment

The monthly payment option fixes a very low introductory interest rate. The loan payment is calculated based on this interest rate, which can be as low as one percent. The payment amount can not increase by more than 7.5 percent per year, but the interest rate is adjusted monthly based on the index tied to the loan.

Every fifth year, or if the unpaid principal balance exceeds 125% of the original loan amount, a new monthly payment amount is calculated based on the current interest index rate. Because the loan payment is fixed and the interest rate moves, it is possible to accrue deferred interest, commonly referred to as negative amortization. The deferred interest is added to the current loan balance. This option provides flexibility when qualifying for a loan during periods of high interest rates or a steep rise in home prices.

Borrowers should be aware that low payments in the early years of the loan could become quite high later on and cause a borrower to suffer "payment shock."

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Interest Only

The interest only option provides relatively low payments while avoiding deferred interest charges that can occur with the minimum payment option. The borrower pays only the monthly interest due on the outstanding balance with no reduction in the principal amount. Low adjustable rates at the outset provide for a manageable monthly payment.

The interest rate is calculated using one of the three indexes above plus a fixed margin, or the interest rate by which lender marks up the loan. The payment amount may change from month to month based on changes in the index. As the index rises, the monthly payment gets higher.

Lump sum payments can also be made on the principal balance if the borrower elects to pay down the loan amount. This option can be a short term solution when qualifying for a new loan as the initial rates are lower than fixed rates, resulting in a lower monthly payment.

Full Amortization

Most borrowers understand the full amortization option. This option provides for a monthly payment of principal and interest the will reduce your loan balance to zero at the end of the loan period. Loan periods are generally of 15 and 30 years, and this option will have the highest monthly payment.

The interest rate is calculated using the same method as interest only, using an economic index plus a fixed margin. However, the payment amount will also include a sum to reduce the principal balance over the payment term. The monthly payment can fluctuate with changes in the index tied to the loan. Full amortization is the fastest method to build equity in the property.

Consider This

Flexible Payment Adjustable Rate Mortgages (FPARMs) allow total flexibility in managing a mortgage loan. Many lenders even allow borrowers to change their payment option on a monthly basis. Loan qualification is easier, and borrowers can manage cash flow based their personal financial situation. The risk factors are possible deferred interest charges and steep adjustments to interest rates and monthly payments.

It is important to remember that the rate charged on interest only and full amortization loans includes the index rate plus a fixed margin. So if the index rate for LIBOR is 2.25 percent and the margin is 2.75 percent, then the actual note rate the borrower pays is 5.0 percent. As a Borrower, know the risk involved when assessing any mortgage product and weigh this risk against your own financial situation.

Mr. Chianese is Director of Quality Control for Meridian Mortgage, Inc.

You can reach him by email at art@mortgage2u.com.