Have you recently come across advertisements for mortgage products that have 1-2% interest rates? The refinance boom is long since over, so it is time to try and get people to refinance needlessly anyway. I frequently come across the same advertisements, so I know how tempting it looks. I think how nice it would be to actually get a 1% mortgage on my own home. This is exactly what the banks want you to believe. The truth is you do not get 1%, except for the first month or three. The bank has absolutely no intention of letting you pay your mortgage at 1%, right from the beginning. I guess that is my biggest problem with the whole thing. The advertising is purposely deceitful and misleading. So I thought it would be worth explaining the Actual Rate you pay on these loans. All Adjustable Rate Mortgages (ARMs) have an Index and Margin they track monthly, annually or semi-annually. This index and margin are added together at the beginning of each period. To simplify things, let’s call that you’re Actual Rate. In addition, all ARMs have Cap or ceilings as regards to how high the interest is allowed to adjust each period or at least over the life of the loan. Many popular ARMs also have an initial period up front, where the rate is locked-in and can’t be adjusted until that initial period has expired.Once an ARM loan starts adjusting, the bank calculates the Actual Rate. As long as the Actual Rate does not exceed any limit set by the Caps, your mortgage rate will adjust (up or down) to the Actual Rate for the next period in question. In essence, there is a reasonable plan set forth, whereby both the bank and consumer can agree to share the risk of rate movements in the future. The disclosures are fairly easy to understand, and the balance of the loan is paid down over time. Many consumers have benefited from using ARMs in general.
Moving on to the Option ARM. The option ARM is constructed so that the borrower has three available “options” to make the mortgage payment. With the 1st option, the payments are calculated based upon a 1% principal and interest payment. The 2nd option allows you to pay interest-only at the Actual Rate (index + margin) and a 3rd option to pay (the real) principal and interest at the Actual Rate. It sounds harmless enough. Consumers will hear the 1st payment option is calculated at 1% principal and interest, and think that means they are actually paying down their loan at the 1%. The payment based on the 1% rate won’t even cover the interest-only amount of the Actual Rate (option #2). The difference between the teaser payment and the Actual payment (option #2) is added back to your principle balance. This is referred to as negative amortization or deferred interest. The rate adjusts monthly with a lifetime cap at 12%. Therefore, you end up paying interest on top of interest. This can be done until the original balance equal 115% of the value of the original loan. Once this occurs, payment option #1 is not available anymore. Right now the Actual Rate on all those loans is in excess of 7.5%. Meanwhile you could get an 30 Year Fixed for less than that, with or without the interest-only payment feature added. Additionally, the loan officer selling this product will make 3 to 4 times the commission compared to a conventional loan program. Therefore, it is in the loan officer’s best interest to sell you this type of loan.
