Your Adjustable Mortgage is Going to EXPLODE!
Wait, not so fast!
Don't believe all you hear. Just because you have an Adjustable Mortgage (ARM, Option ARM, Hybrid ARM, Left ARM, Right ARM of the Law, etc.), DOES NOT necessarily mean you are in serious trouble. What MAY get you into trouble is if you don't UNDERSTAND what is going to happen to the loan when it DOES adjust!
First, just like Whiskey there are many different types of ARM's out there. On the surface to the untrained they may all smell the same but they are way different! Let's outline the different types of Adjustable mortgages.
Option ARM's
Known Aliases: "1 Month Option Arm", "12 MTA Pay Option ARM," "Pick a Payment Loan", "1-Month MTA", "Cash Flow Option Loan", "Pay Option ARM", "Hybrid Option ARM", "My Broker told me it was a 1% 30 Year Fixed", and more.
All of these loans have their own different tastes but in general the share the same features:
- Minimum Payment due monthly (based on a 1-2% Pay Rate) which is LESS than the Interest actually due on the loan (based on a 5-8%+ Interest Rate!
- Negative Amortization Possible (and most likely!) This means that instead of paying your balance DOWN, it goes UP!
- Adjustable Feature in either the Pay Rate, Interest Rate or Both.
- Recast. Recast is when due to the negative amortization your principle balance climbs to a pre-determined level (110%-125% of your original loan amount as outlined in your Adjustable Rate Rider, Note or other instrument you signed and had notarized) you no longer had the attractive minimum payment and instead have the full-amortized payment (both Principle and Interest) which could be more than double or even triple what you were used to.
- Pre-Payment Penalties of 0-3 years of roughly 6 months worth of interest payments.
These loans first came on the scene in the mid 80's to combat the normal Fixed Rate loans which were in the 9-10% range. They offered payment caps as opposed to interest rate caps. Not bad, but unfortunately these loans increased the principle owed on people's mortgages at an alarming rate. When things did settle, these loans were good for the short term for people looking to own for only 1-3 years or for investors looking for an increase in monthly cash-flow. Fast-Forward to the early 2000's and these loans become popular for different reasons:
- Buyers could get a home they really couldn't afford. This was OK to buyers and their trusted advisors because with the minimum payment, it was now affordable to live in a $1m McMansion.
- Values were climbing without an end in sight. No one worried about rising balances because this figured paled in comparison to appreciation. Get into a bind? No problem, refinance out of it!
- Investors loved their return on these loans (increased balances due, pre-payment penalties, increasing values, etc) so they in turn paid Lenders and Brokers pretty impressive commissions for selling one of these to a borrower. If you as a borrower don't understand YSP (Yield Spread Premium also known as Rebate) and you didn't care about your Interest Rate on these loans just your minimum Pay Rate, your Broker or Loan Officer could have earned as much as 3% or more directly from the Investor in addition to any origination charged to you directly.
Short Term Fixed ARMs
These loans generally had a short term period of a fixed rate followed by a long term period of an adjusting rate. Subprime loans were famous for being fixed in the shortest of terms and known as 2/28's or 3/27's to name a few. The "2" or "3" mean the loan was fixed, usually at a decent rate, for 2 and 3 years, respectively, and adjustable for the remaining 28 or 27 years. Subprime loans also further evolved into the 2/38, 2/48 (yes, it existed) and all other sorts of flavors. Other types of these ARMs were notated as 1/1, 5/1, 10/6 and so on. The 1st number represents the amount of time the loan was fixed for, (1 year, 5 years, 10 years, etc) and the 2nd number represents the interval of adjustment AFTER the fixed period; a '6' means every 6 months whereas a '1' means every year. Get the idea?
Some of the most savvy investors opted for the really low rates of the 1/1 ARMs, playing the market. Other borrowers opted for the 7/1 or longer fixed periods as lower rate alternatives to a 30-year fixed loan. If you only planned on owning a home for 4-5 years, this made sense.
When will my loan adjust?
If you are reading this now (August 8th, 2008) and you have an Option ARM and you have been making only your minimum payments, you most likely need to refinance right away. If you borrowed 80% the value of your home when you originated the loan, you are most likely up-side down and should talk to your lender about a Loan Modification so you can sleep at night. If you have been making your interest-only payment or even the fully-amortized payments, your rate may be where market rates are or possibly even better since the indices (see below) have been performing fairly well.
Now, to determine WHEN your Short Term Fixed ARM will adjust you will need to pull out your original loan documents. It doesn't matter what you remember or what your Loan Officer told you, it's what you signed that matters. If you cannot find your loan documents don't worry, you can obtain a copy at your County Recorder's Office or even a local Title Company. What you are looking for is a document (2-5 or so pages) that is entitled "Adjustable Rate Rider" or something to that affect. Click the image below to zoom in on the sample.
About half-way down the page is a section numbered 4 entitled "Interest Rate and Monthly Payment Changes". Click the image below to see a close up. If you pay attention to the details, you will see there aren't #'s 1-3. I have no idea why they were missing. Anyways, you see that 4 (B) is clearly labeled "Change Dates". Clearly states the date the loan may change and also how often the loan may change, 6 months. If you notice on the above sample that this particular loan was created April 16th, 2003. With a Change Date May 1, 2008 and with a potential change every 6 months, this loan is nicknamed a "5/6 ARM". Get it?
How is my rate determined when my loan starts to adjust?
When your loan adjusts, it is based on two numbers: a margin and an index. The margin is fixed for the life of your loan and is outlined in your original loan documents. It may not say exactly "your margin is ____" but may say something like "... the Note Holder will calculate my new interest rate by adding ____ % to the Current Index". Click on the image just above and you will see in section 4(C) "Calculation of Changes" the exact wording of this particular loan. Yours should be similar.
The index is the adjustable portion of your loan. There are many different indices: 12 Month MTA, 11th District Cost of Funds (COFI), COSI, CODI, T-Bill, LIBOR (6 month and 12 month flavors), Prime Rate, etc. The MTA, COFI, COSI, CODI and T-Bill were popular with the Option ARMs, the LIBOR was popular with the Short Term Fixed ARMs and the Prime Rate is attached to most of your Home Equity Lines of Credit (HELOC) and Credit Cards. Again let's look at the above sample. The index for this particular loan is outlines in 4(B) "The Index". Indices are generally published in your local newspaper in the Investment or Real Estate sections or available online on about a million different websites. I like to view them here.
When your loan is about to adjust, simply take the margin and add it to the index. That magic number is your new rate! This can be higher, lower or the same as your current rate.
Michael, wait! Is there a limit to how it can change? I mean, what if it’s really, really high?
No need to worry (or maybe you do need to worry), your loan has limits on how high it can go, how low it can go and on every subsequent change (every 6 or 12 months as we discussed) there are other caps. Click the image below zoom in on a sample of the same Adjustable Rate Rider we've been talking about. Section 4(D) states that on the first Change Date, the rate will not be greater than 10.875% nor lower than 2.25%. For this particular loan, a 10.875% is a 5% increase from what this borrower had been paying for 5 years. This could be a shock. But don't worry! The current 6-month LIBOR is at 3.1184 and the margin on this loan is a 2.25. This means the rate has actually decreased to 5.368%!
Michael, wait! This is awesome, I understand now but... what happens 6 months from now? This loan says it will adjust every 6 months!
Again, no need to worry. 4(D) also tells us that after this first adjustment, all future adjustments will never be greater than 1% of what the previous rate was at. Also, the life-cap on this loan is 10.875% which means it can never be higher than that, even 20 years from now.
I've done my homework, I know my loan will adjust for the worse and I can't afford it. What now?
You have a few options. First and cheapest is a Loan Modification. You contact your current lender and let them know what's going on. Tell them your calculations, tell them you can't afford the new payment and they can possibly help you by either keeping your rate the same or maybe even offering you a lower rate. You can also hire someone with experience to do this for you.
Second option is to refinance into a fixed loan. You can call me (888 989 6533) and I would be more than happy to go over options with you.
What? You owe more than your home is worth?
You can refinance up to 97% the value of your home with an FHA loan and ask your current lender to either forgive the difference OR carry a 2nd Mortgage above and beyond what the home is worth. This is allowed by HUD but good luck getting your current lender to play ball!
More realistically, thanks to the new Housing Bill you can possibly refinance into an FHA loan for 90% of the current value of your home with a few caveats:
- You will pay Mortgage Insurance on your new loan just like every other FHA loan (unless its a 15 year loan under 90% LTV).
- You will share future equity in your home with the Government.
- You will pay increased fees to the Government for these loans.
Note: As of this writing, these new changes to HUD have not yet been implemented and even when they do; it may take some time for Lenders to work this into their systems.
Lastly, if it makes sense for you, you can always sell your home under a short-sale agreement with your current lender.
Summary
I hope that by reading this post you have a better idea as to how your ARM works and that you have the knowledge now to know if you are in trouble or not. Knowledge is Power.
Michael Wolff
