Mortgage Products – hybrid and adjustable rate/payment mortgage
The following mortgage contract rates displayed below have been taken from www.bankrate.com sometime ago and are used for demonstration purposes.
Type Contract rate
30-year fixed 5.13%
Jumbo 30-year fixed 6.06%
30-year fixed, 6 points 4.15%
30-year FHA 5.74%
15-year fixed 4.70%
1-year ARM 3.98%
5/1 ARM 4.30%
The table above shows the relationship between various contract interest rates. All of these quoted rates are ‘prime’ and only available to mortgagors with good credit. Subprime mortgage rates would be higher, reflecting more risk of a lower credit rated mortgagor.
Note the 93 basis point difference in the 30-year fixed rate of 5.13% and the Jumbo 30-year fixed rate of 6.06%. This difference in rates is referred to as the non-conforming loan spread because jumbo loans are higher than the maximum amount that Fannie Mae and Freddie Mac will purchase. Fannie Mae points to this spread to proxy the liquidity that a secondary market provides to the primary mortgage markets.
Note the 98 basis point spread between the 30-year fixed rate with no points (5.13%) and the 30-year fixed rate with 6 points (4.15%). This is an example of buying down the contract rate of interest by paying points.
Note the 61 basis point spread between the 30-year fixed rate (5.13%) and the 30-year FHA rate (5.74%). This spread is attributed to the higher loan-to-value ratios and additional origination requirements of FHA mortgage loans.
Note the 43 basis point spread between the 30-year fixed rate (5.13%) and the 15-year fixed rate (4.70%). This spread represents the lender’s required return for having their money tied up in a fixed rate for an additional 15-years with the 30-year mortgage. You may even expect a larger spread for double the loan length, but don’t forget that the typical mortgage tenure is 5 or 10-years.
Note the 115 and 83 basis point spreads between the 30-year fixed rate (5.13%) and the 1-year ARM and the 5/1 ARM rates, respectively. The 1-year ARM is a standard adjustable rate mortgage (ARM) and has an fixed interest rate only for the first year. The rate is then reset or adjusted at the beginning of each of the 29 remaining years, assuming a 30-year term. So, it is important to note that the ‘1-year’ is the adjustment period and not the loan term. Although a 1-year adjustment period is typical, the adjustment period could be as short as a month or as long as several years. ARMs are commonly amortized over a 30-year term, but longer or shorter terms are also available. Although the interest rate and mortgage payments can change each year, the mortgage principal is amortized over the life of the mortgage and paid down to zero with the last mortgage payment.
The 5/1 ARM is a hybrid mortgage product that acts like a standard fixed rate/payment mortgage for a specified number of years and then turns into an adjustable rate mortgage thereafter. The amortization term is normally set to 15 or 30 years. With a 5/1 ARM hybrid mortgage, the contract interest rate is fixed for five years, 4.30% in this example, and then turns into an adjustable rate mortgage, a 1-year adjustable rate mortgage in this example. Other hybrid mortgage products include the 3/1, 7/1, and 10/1 mortgages with a 3, 7, and 10 year fixed periods, respectively. Note that the spreads between a 30-year fixed contract rate and the contract rates on the 7/1 and 10/1 are generally modest. Again, this is because the typically 30-year mortgage is paid off in 5 to 10 years anyways.
The reason for the lower contract interest rates on the ARMs and hybrid mortgages, compared to the 30-year fixed rate, is due to the transfer of interest rate risk from the mortgagee to the mortgagor. If the mortgagee has less risk, they receive less return. If interest rates rise, the mortgagee’s ARM payments will increases.
To entice a mortgagor to take on the interest rate risk, a lower initial contract rate is required. Also, lower interest rates help marginal mortgagors qualify for loans. At times, mortgagors agree to adjustable rate mortgages because they do not qualify for a 30-year fixed rate mortgage. Very low first year rates on ARMs are called teaser rates because they entice, or tease, mortgagors to select the ARM, but the teaser rate adjusts upward after a specified period. This is why we like the old fixed/rate payment mortgage. You know exactly what each mortgage payment will be. Please evaluate teaser rates carefully!
Adjustable rate mortgage products typically have interest rate caps. A periodic cap is a limit on a contract interest rate change over an adjustment period (for example, 1% per year). An over-all cap places a ceiling on the interest rate change over the life of the mortgage (for example, 6% total over the 30-year term). Caps prevent drastic changes in mortgage payments in volatile interest rate periods.
The contract interest rate on an adjustable rate mortgage is composed of an index plus a margin. Common indices used include LIBOR (London Interbank Offer Rate) or the one-year US treasury rate. The margin spread account for the risk and management responsibilities over an above a relatively risk free return. Therefore, if the one-Treasury rate was 2.5% and the margin is 250 basis points or 2.5%, then the ARM contract rate would be 5%. At the end of an adjustment period, the index is consulted to set a rate for the next period. For example, if after one year the one-year Treasury rate is now 3.9%, then the new contract rate is 6.4% (3.9% +2.5% margin). However, do not forget about any caps. If the ARM had a 1% periodic cap, the new contract rate would be capped at 6% (5% + 1% cap). See ARMs can be tricky to keep track of.
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