Adjustable Rate Mortgage (ARM)
The adjustable rate mortgage (ARM) is a home loan whose interest rate
and payment are adjusted periodically throughout the life of the loan.
Though the initial interest rate is lower than traditional 30 year fixed
rate mortgages (also known as a "teaser rate"), the actual interest rate
is dependent upon several factors:
The index: This is a published market rate such as the U.S.
Treasury Bill, 11th District Cost of Funds Index (COFI), or the London
Interbank Offering Rate (LIBOR).
The margin: This is a set percentage that is added to the index
to calculate the current interest rate. Margins will vary from ARM to
ARM.
The caps: Interest rate caps protect the consumer from wild
shifts in interest rates changes from one payment period to another.
There are two caps that a borrower should look at: 1) the adjustment cap
that limits how much the interest rate may increase or decrease between
each adjustment; and 2) the lifetime cap that limits how high or how low
the interest rate may be over the life of the loan.
Though many consumers are initially wary of a mortgage whose interest
rate can increase during the life of the loan, there are many situations
where this type of financing is advantageous for a home owner. First,
if the borrower anticipates an increase in income in his/her future, the
ARM may allow the buyer to purchase a larger home than he/she would have
normally qualified to buy. Second, ARMs allow a borrower to take
advantage of declining interest rates due to the a declining index
without the expense of refinance the mortgage. Third, ARMs allow home
buyers to spend less on interest costs if he/she plans on living in the
home for less than five years. Fourth, if the borrower pays additional
principal each year towards the loan, the future payments are calculated
upon the lower principal amount rather than the original loan amount.
In time this may translate into lower monthly payments and/or lower
interest costs.
The major drawback remains the potential for a higher interest rate
which results in a higher monthly payment in the future.
The following are highlights of this loan program:
Adjustment period: Once every 12 months the interest rate is
recalculated using the margin and index.
Margin: 1 Year U.S. Treasury
Caps: Adjustment cap of 2% and lifetime cap of 6%
Down Payment Requirements: The minimum down payment required for
this type of loan is 5% of the sales price for owner-occupied
properties. Buyers purchasing a second home are required to put a
minimum of 20% down on the home. Real estate investors and non-owner
occupied buyers are not eligible for this type of loan. Down payment
requirements will vary with the number of units and the reason for the
loan (i.e. purchase, rate and term refinance or cash-out refinance).
Income and employment: There are no limitations placed upon
income requirements. As for employment, there are no limitations on a
specific length of time at a particular job. However, a 2 year history
is required, preferably in the same line of work (education can be
counted towards this 2 year history if it is for the same profession the
borrower is currently in).
Eligible properties and occupancy requirements: Single family
attached and detached homes, 2 to 4 unit properties, planned urban
developments (PUDs), and Freddie Mac approved condominiums.
Closing Costs: Closing costs and prepaids may be paid by
interested parties (i.e. seller) as long as they are considered in the
contribution limitation. For primary residences, the seller may
contribute up to 3% of the sales price if the buyer is putting less than
10% down otherwise the seller can contribute up to 6% of the sales
price.
Assumability: Yes, with the approval of the lender. The buyer
must credit qualify to assume the existing loan.
Pre-payment Penalty: Not applicable.
Cash Reserves: The borrower is required to have a minimum of
two months cash reserves in the bank by the close of escrow. Proceeds
from cash-out refinances are not considered reserves.
Gift Funds: Gifts are allowed on owner occupied and primary
residence transactions only. If the down payment is 20% or greater,
100% of the down payment may be gifted otherwise the borrower must have
at least 5% of his/her own funds to contribute to the down payment.
Credit Scoring: Generally Fannie Mae and Freddie Mac require a
minimum credit score of 620 for owner occupied and second homes.
Co-Signors (Non-Occupant Co-Borrowers): Allowed on purchases
with a minimum down payment of 25% of the sales price.
Qualifying Ratios: Fannie Mae and Freddie Mac limit a borrower's
monthly payment not to exceed 28% of their gross monthly income. A
borrower's total debt (proposed monthly payment plus monthly payments
towards credit cards, student loans, car payments, and other installment
and revolving credit) cannot exceed 36% of their gross monthly income.
If compensating factors are present or if the borrower has an above
average credit score, the stated ratios may be exceeded.
Mortgage Insurance: Required for all owner occupied purchases
with a down payment less than 20% of the purchase price. If the
property is a second home, mortgage insurance may be required when the
down payment is less than 25% of the purchase price.
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