Candidate For Rate Shock? Some Suggestions, Maybe Some Comfort
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Now that the housing
bubble has officially started to deflate we can turn our worries to the
newest wiggle: Rate
Shock.
At least three of the major television and cable networks have run stories
in the past week about the danger confronting homeowners with adjustable
rate mortgages when those rates adjust. Experts estimate that 25 percent
of all loans are adjustable rate mortgages and billions of dollars worth of
these will adjust in the next year. Because of compounding factors such as rising
energy costs, static wages, and a softening housing market, these adjustments
may just price many people out of their own homes.
Exacerbating the problem of rising mortgage rates and falling property values
are what the Association of Community Organizations for Reform Now (ACORN) calls
"layered risk loans". As we reported in an earlier article about a study conducted
by this group, some homeowners who have opted for ARMS have also further cut
payments by choosing "interest only" or optional payment types
of these loans. Both of these have the possibility of greatly reducing the amount
of equity that has been built and the optional payment can even result in a
higher principal balance than the original loan.
If you are in this position, with a mortgage that will be adjusting (or maybe
recently has) and especially since rates are now down a bit from recent highs,
it is time to evaluate your position and make a decision whether refinancing
your mortgage or mortgages makes sense or is even possible.
Can you refinance?
The shear ability to refinance into a fixed rate mortgage or even an ARM with
longer term stability may be the determining factor for many people. If a home
was in an area without the phenomenal run-up in value that was seen in many
places or if a homeowner has repeatedly refinanced in order to draw out funds
for bill consolidation, home improvements, or financing lifestyle choices, the
equity may simply not be there to allow refinancing. Lenders are not, at this
time, banking on future home value appreciation to fudge borderline loans.
Homeowners who are already in trouble from rising rates or other financial
problems may also be unable to secure reasonable refinancing. An existing mortgage
delinquency or a pattern of recent late payments on other bills will make a
new mortgage at market rates virtually impossible.
Should you refinance?
There are a multitude of variables that will determine whether a refinance
is a reasonable solution. First of all, do you know the parameters of your mortgage
note?
The ACORN study reported that a large number of people with ARMs have no clear
idea about the terms of their mortgage. Will it adjust? When is the adjustment?
How is the adjustment determined? And most important, what is the bottom line,
i.e. the size of the check you will have to write after the rate adjusts?
Look at your mortgage note. You were given a copy at closing and it contains
all of the terms regarding this adjustment. It will give the initial mortgage
rate and the date and frequency of any adjustments It will also give the basis
(or index) upon which the new rate will be determined and the margin i.e., the
additional amount that will be added on to the index. Some of the more common
indexes are the LIBOR (see below), the monthly average yield on three year treasury
securities or the 52 Week Treasury Note. The current LIBOR
indices can be found at www.fanniemae.com/newsreleases
and many other treasury indices can be found at http://www.indymacb2b.com/news/currentIndices
or in most of the larger daily newspapers and the Wall Street Journal.
For example, your mortgage may be pegged to the 6 month London Interbank Offered
Rate (the LIBOR) which this week was at 5.43130 percent. If your margin is 2.75
percent, your new rate will be 8.18 percent. Next, use a rate calculator such
as the one on this website and enter your current principal balance, the new
rate, and the number of years (or months) remaining on your mortgage. Example:
a balance of $135,000 for 29 years. The resulting number, $1,015.76 will be
your new mortgage payment, not including any required escrows for property taxes,
insurance, or private mortgage insurance.
If you hair is now standing on end, relax. Most prime mortgages have rate caps.
These go along way in muting the effect of the adjustment. Caps are usually
expressed as 1/5, 2/6, etc., which means that the rate cannot increase more
than the first number - one or two percent - in any one adjustment or by any
more than the second number - five or six percent - over the life of the loan.
Thus, in the LIBOR example above, if your loan originated in October, 2005 when
the average rate was 4.51 percent and has a 2/6 cap your rate cannot shoot up
to 8.18 percent but only to 6.51 percent because of that cap. This would result
in a new payment of $863.82 using the example above. During the entire 30 year
term of the mortgage your rate can never be higher than 10.51 percent because
of the 6 percent lifetime cap. These caps, however, also mean that, should rates
drop over the next few years, you can benefit only to the extent of the caps
which limit the decreases in the same measure that they limit the increases.
Some caveats.
Lenders have been offering "teaser rates" on ARMs for years
but this promotion has been particularly notable in the last year as rates moved
up from historically low levels. With a discount or teaser the loan is discounted
from the going rate for an initial loan period to make an ARM more attractive.
These teaser rates react in different ways but be aware that they will always
return to the index rate plus the margin - in other words, what they ordinarily
would have been. One example: the introductory or teaser rate started at 4.0%
interest and would adjust upward 1.0% every six months. If your index for this
loan was 5.0% and the lenders margin was 3.0%, then the interest on your loan
for the first six months would be 4.0%. Six months later, it would increase
to 5.0% and so on until the fully-indexed rate was reached. To find the fully-indexed
rate, you would add the index to the margin (5.0% + 3.0%). After the fully-indexed
rate was reached, your loan would then fluctuate with the index on your loan.
In another example, an initial rate of 5 percent is discounted to 4.5 percent.
At the adjustment the new rate would be calculated from the real rather than
the discounted rate which would override any cap. In other words, if the newly
calculated rate is 7.5 percent and the cap is 2 percent the rate would wind
up at 7 percent rather than 6.5 percent. If this is making your eyes cross,
contact your original lender for an explanation.
A second warning when evaluating your current loan: there are a few sub-prime
loans floating around that have some bizarre conditions. One variety,
for example, will only adjust upwards. If rates go up you pay more but if they
go down you do not benefit. There are also mortgages out there with only one
type of cap - an adjustment cap which controls a single increase or a lifetime
cap. Thus, your rate could increase every year forever (or until it hits your
states maximum usury level) or it could take a single mega-jump up to the lifetime
cap. Still other variations include a longer static period - perhaps two or
three years, followed by frequent adjustments such as every six months for the
life of your loan. Again, read your note!
Now that you have a better idea of what the future holds, you do have a few
options and we will talk about some of these in an upcoming article.
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