Minnesota Mortgage Man

Adjustable rate mortgages have their place in the world of mortgage lending, primarily for the big risk takers and more specifically, the short term investor looking for quick cash flow.

Why the investor? Adjustable rate mortgages or variable rate mortgages or whatever you want to call them, are typically great short term cash flow tools. I don't recommend them for anyone that is thinking about holding the property for more than a year. They are also a great product for mortgage brokers and bankers to sell because the retained profit can be hidden very easily in the margin. We'll talk about that more in a bit. If you are not an investor and you are being recommended an adjustable mortgage, be careful and watch the details. Not only can they be loaded with traps but they also require additional underwriting which may cause loan approval concerns.

Let's look at the structure of an adjustable mortgage and its features. Afterwards you may be better able to understand how they work, and why they may or may not be a good program for you.

Adjustable rate loan programs are comprised of two or three components: the margin ( margin of profit for the bank ) and the "index" ( cost of money ). A simple way to think about what an index is, is to compare it with a retail product. A retailer will by a product at a cost, in the banking world that's called an index. The bank lending you the money for your property purchase or refinance borrows that money from an investment money supply source at an indexed rate. Lets say the specific money source ( could be national or international ) such as the Bank of London, which is offering a LIBOR index. The rate (cost) of this index is, lets say 6.5%. This means that the bank is getting the money at 6.5%. If the index adjusts every three months, then the rate of 6.5% will adjust (mostly up) every three months for the bank or consumer.

If the bank "buys" the money at 6.5%, can they really lend it to you at 6.5%? Obviously not. The bank must add on a profit MARGIN. This is called... you guessed it, the margin. A typical margin will range anywhere from between 2% to 4% depending on the lender or mortgage broker. So, now we have two components: Margin and Index. Translate that to numbers and you'll have what's called a fully indexed rate. In our example, 6.5% index plus a 2% margin, equals an 8.5% fully indexed rate. Your principle and interest will be based on the fully indexed rate.

Wait a second... my mortgage broker and abcmortgagescalpers.com and Sly Savings and Loan was offering an adjustable rate loan with a start rate of 1.95%. you don't know what you're talking about.

au contraire...

A start rate (third component) really doesn't have much to do with a fully indexed rate. A start rate is a lovely little invention of adjustable rate mortgage sellers that is tantamount to a spider web. And guess who is the fly. Go ahead guess.

If borrowers knew exactly how adjustables worked, they wouldn't give these loans a second look. That's why lenders created the "start rate feature". The lenders that promoted these loans most were Washington Mutual, World Savings, Downey Savings, Countrywide and IndyMac Bank. Guess what all these banks have in common?

Typically the start rate on an adjustable is what's known in the industry as a "teaser" rate. It can be anywhere from 1% to 3%, and last anywhere from one month to one year. We are not seeing very many that last more than six months, and truth be told, most actually are lasting from one month to three months.

So how does the start/teaser rate work? The start rate is a negativily amortizing rate. That means that if you pay the 1 or 3 or whatever percent start rate, your loan is not going down like it should. It's actually growing and eating at your equity, or simply put, making your $300,000 loan into a $350,000 loan.

Because the bank is paying 6.5% for the money plus the 2% margin they require to make a profit, and you as the consumer are only paying, say 1.95%, then the difference between what you're paying, and what the bank HAS TO EARN AND PAY must be put back on top of the balance of what you owe.

Yes, some banks actually make the 1.95% a fully amortizing loan rate BUT BUT BUT that is only for a very short period of time. In retailing, that's called a "loss leader". After this teaser period, the loan has to start catching its fully indexed rate or the bank is paying you to take their money. That means that the rate starts increasing at each payment cycle.

The loan can't jump wildly, we know that because someone mentioned "caps" in an earlier article. Caps are nice but often more like the proverbial bucket of water on a camp fire, they do just enough to cool the effect of the fire but not enough to put the fire out.

The typical cap on adjustable loans is 7.5% of the payment. This means that each payment can't increase more than 7.5% of the previous payment amount. If payment one is $500, then payment two can't increase more than 7.5% or $37.50 for that $500. So payment two will be $537.50 and so on and so on and so on until the rate catches its fully indexed rate of 8.5%. In essence, a borrower could have a loan that does NOT stop increasing until it reaches the indexed rate or its "life" cap or annual cap.

Life cap, Annual cap? What are those? Annual caps don't get reached usually so I'll talk about life caps. The explanation works for both annual and life.

Life caps are a safety feature Uncle Sam requires on most of these loans. Life caps hold a loan rate from going up unlimitedly. Typical life caps are 5 or 6% above the index. If your index is 6.5%, then your life cap may be 11.5% or 12.5%. These loans also have "floors" which are usually the index of 6.5%.

Are there different indexes? Yes. There are lots of different indexes. Some quicker to adjust and some slower. Some more volitile and some less so. Popular indexes are the LIBOR, MTA, COSI and COFI. You'll have to check here to see what your index is today because they change daily with the markets: Public Market Snapshop

Did I overload you? Let me throw one more piece of the puzzle out. How are margins established? I said earlier that a margin could be anywhere from 2 to 4% or more or less. Margins are set by the bank or broker depending on how much the bank or broker wants to make. A margin has nothing to do with the start rate. You can be offered 1.95% as a start rate but have any margin- 2, 3, 4, 5, etc.. The bank will be paid less on a margin of 2 than on a margin of 4. Again, it doesn't effect your start rate. That's the trap. Everyone, including you is looking and drooling at the start rate. No one looks at the margin and that's where the trouble starts and has started.

Here's a chart on adjustable mortgage resets.