Categories
Mortgage Matters

What are Adjustable Rate Mortgages?

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Most people have lots of questions about adjustable rate mortgages (and little bit of fear). Rightfully so. But before we discuss the specifics on an adjustable-rate mortgage (ARM), let’s first discuss fixed-rate mortgages.

Fixed-rate mortgage (FRM)

A fixed-rate mortgage (FRM) is a mortgage with an interest rate that remains the same over the entire term of the mortgage, regardless of how interest rates change in the marketplace.

Who benefits?

Customers who:

  • Finance their home when rates are relatively low.
  • Want the predictable principal and interest payments over the long term.
  • Seek protection from rising rates and monthly principal and interest payments.

What are the drawbacks?

  • Generally, the interest rate is higher than the initial rate of an ARM.
  • If the interest rates in the marketplace decrease, your rate will not adjust to a lower rate unless you  refinance to a new mortgage.

So now let’s look at an ARM.

Adjustable-rate mortgages (ARM)

An adjustable-rate mortgage is a mortgage with an interest rate that is fixed for a specific period of time then changes at scheduled dates to reflect market conditions.

The initial interest rate is usually lower than on a fixed-rate mortgage, making your initial payments lower too.

The interest rate is based on a market index that is subject to change plus a margin that does not change.

Market index: A published rate, such as the prime rate, LIBOR, T-Bill rate, etc.

Margin: The set percentage the lender adds to the index rate to determine the interest rate of an ARM.

The initial interest rate is the total of these two values plus or minus small adjustments made by the lender due to market conditions. 

When the initial interest rate adjusts, and at each subsequent adjustment, the interest rate will be the total of the market index and the margin, subject to any increase or decrease limitations, often referred to as rate caps or floors. 

After the initial interest period, the interest rate can adjust up or down at regular intervals based on changes to the market index.

The following are descriptions of when the interest rate may adjust for different ARM products:

  • A 6-month ARM adjusts up or down every six months.
  • A 1/1 ARM adjusts up or down for the first time after 1 year, then every year after that.
  • A 3/1 ARM adjusts for the first time after 3 years, then every year after that.
  • A 5/1 ARM adjusts for the first time after 5 years, then every year after that.

Who benefits?

Customers who:

  • Will move and/or sell their home before the first interest rate adjustment.
  • Want the ability to pay a lower monthly mortgage payment during their first year(s) of homeownership.
  • Finance their home when fixed rates are comparatively high.
  • Have sufficient income to manage a potentially increasing payment if refinancing or sale is not an option.
  • Are willing to take a chance that their rate will stay the same or decrease when it adjusts.

What are the drawbacks?

If your interest rate increases at adjustment, you may experience “payment shock” if your monthly payments increase to an amount you may be able to maintain along with your other monthly obligations. Yikes!

If refinancing or selling is not an option, you could be at risk of losing your home. So be realistic and take caution when considering an ARM.

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Dana Ash-McGinty

Principal Broker | Realtor® | “The Real Estate Maven”

Dana Ash-McGinty is the Principal Broker of ASH | MCGINTY, a Washington, DC Real Estate Brokerage. This real estate maven has 15+ years experience in residential, commercial and land sales in addition to multi-state residential renovation, re-zoning, and condo conversion projects. A sought after real estate authority, she has been featured on CNN and in various real estate and financial publications. Dana is married to the highly esteemed Dr. Dana W. McGinty, a Washington, DC based internal medicine physician. They are often referred to as “The Danas”.

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Categories
Mortgage Matters

Interest Rate vs. Annual Percentage Rate

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At ASH MCGINTY, we understand the important role your home plays in your your life. That’s why we are committed to providing you information that will help you make more informed decisions about your home financing.

So, let’s simplify it, starting with interest rate vs. annual percentage rate (APR).

What is an interest rate?

The annual rate you pay on the funds you borrow. You have the option of choosing:
  • A fixed-rate mortgage (FRM) [For example, I’m sure you’ve heard of “30 year fixed-rate mortgage“.]
  • An adjustable-rate mortgage (ARM)
  • A temporary buydown of the interest rate or initial monthly payment.

What is an annual percentage rate (APR)?

When you choose your mortgage, you are quoted an “interest rate“, which may vary until it’s “locked in”, that established the initial amount of your monthly principal and interest payments.

You should see both an interest rate and an annual percentage rate (APR) in various documents. The APR, which is usually higher than the interest rate, expresses the cost of the mortgage as an outgoing annual rate and includes certain fees, points, closing costs and other expenses (even though they are paid at application, or before or at closing).

APRs can help you compare types of mortgages and the costs between mortgages or lenders, but remember that the APR is different from the actual interest rate on your mortgage.

I will repeat- The APR is different from the actual interest rate on your mortgage.

How is the interest rate determined?

Many factors determine the interest rate on a particular mortgage. Your rate will reflect conditions in the financial markets and your mortgage type, as well as an assessment of the risk of your specific mortgage product and your credit.

Catch this- This is why a rate found online may not provide enough information or reflect the interest rate you will actually receive once a lender has assessed your specific circumstances.

Mortgages reflect the conditions in the financial markets.
Complex variables affect the ride and fall of interest rates. This is why we see rates published daily. It’s most important to understand that there is no “one mortgage rate“.

Rates can fluctuate not only daily, but even hourly with movements in the financial markets, and by mortgage type and mortgage amount.

Additionally, the interest rate on your mortgage depends on the risk your mortgage features represent.

When lending money to customers to finance their homes, lenders and their investors take the risk that these customers will not pay back the money loaned to them.
  • Lenders typically offer lower mortgage rates on mortgages that present less risk.
  • Based on many decades of lending, there are many factors that reduce or increase risk have been identified, including down payment amount, credit score, and other factors.
  • Customers with higher credit scores historically default less often (so the lender anticipates less risk) than those with lower credit scores.
  • A customer with more money invested in a mortgage with a higher down is considered less risky than a mortgage with a lower down payment.
  • Other factors are similarly considered: your debt level in relation to your mortgage amount, whether your home is your primary residence or an investment property, whether it’s a single-family or multi-family home, the mortgage term you need or want, the amount of documentation you provide, etc., etc., etc.

Thing to consider if you decide to “shop rates” among lenders

  • A rate that’s not based on the full details of your specific circumstances can only be a guess. Yes Boo, it’s just a guess.
  • A guess you obtain today from one lender versus a guess you obtained yesterday or a week ago from another lender offers little (aka zero) basis for an accurate comparison.
  • Here’s a simple one– different mortgage types and different mortgage terms have different rates.
  • Be sure to understand whether the rate you are quoted is an introductory rate, sometimes called a “teaser rate”, that might rise dramatically a short time after closing.

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