Single mothers looking to finance their first home will run into all types of mortgage options. This is a narrative that will not only explain to you what an adjustable rate mortgage is but also how it works. It will also touch upon the pros and cons of this type of mortgage. Not all mortgage types will be a good choice for a single mother. Knowing more about each type of loan will enable you to make an more informed decision.
What is an adjustable rate mortgage?
Also called a variable rate mortgage the ARM is a way to finance the purchase of a home that has a rate that goes up and down. Although a very useful loan for getting into a home, they are often easier to obtain than any other type of mortgage, getting this type of loan comes with major risk factors. This will report will only cover some of the basics for you to try to help you understand what it is and how it works. This will help you to determine if it is worth the risk for you and your family.
These mortgages are unique in that the interest rates adjusts with the rise and fall of the prime lending rate of the security your loan was drawn on. If the rate rises so does your loan payments and if they go down, you getting the picture, right. The rate is determined by the current market index. These are the methods used to evaluate certain portions of the stock market. Your loan will be tied in with one of the following indexes, the LIBOR, the Prime rate, the Cost of Funds and there may be others out there that are used by certain lenders. If interested in knowing what index and why your rate is attached to it you can ask the mortgage broker.
One of the reasons this type of loan is attractive to first time homebuyers is that you pay a lower monthly payment at the start. This is usually for the first 2-5 years of the life of the loan. The lender offers this tremendous bargain in the beginning because of the inherent risk you, as the borrower will be accepting for the future. They know if they give you a fixed rate loan and the market is low they are stuck loaning money at a ridiculously rate that will not increase to cover a higher market rate over time. The loss incurred is theirs. The ARM is more useful to the lender since it gives them recourse to charge the current going rate on the money they have already loaned you.
How it works
Most ARM’s have an initial low rate for the first few years of the loan period. The ones that go beyond a 5-year period are now being referred to as “FRM to ARM Hybrids” it is included here because you may run into this term when searching for a mortgage online.
What you will most often see quoted is what is called an initial rate. This rate is only good for a set period of time. This time can be anywhere from 1-2 months up until 5-10 years. If it’s for one or two months only it is hardly worth the trouble of filling out the forms.
To get the lowest rates possible you will be looking for one that has an initial period only lasting 1-2 years. The typical rate on a 10 year ARM is around .25% under what he rate would be on a FRM. Rates Vary on ARM’s depending on the initial periods and the coverage time. They are also controlled by the market yield curve, this is the graph that shows how the prices are expected to be in any given period of time. If the slop goes upward than the rate differential between the ARM and the FRM is bigger. If it is sloping down or is flat, the lender knows he will not stand to make much of a profit on the loan. This is also the one tha t is best for borrowers to get in on.
The Adjustable rate Mortgage strategy
For that savvy borrower this is what they live for. The low interest rates on an ARM allow them to get into the house and just before the time expires on the interest rate they refinance for a fixed rate mortgage or sell the house. This type of strategy works only if you are sure you can refinance or are certain that you will be moving in the given time frame.
In addition another consideration would be that you are not quite sure you will be able to move out in that time frame but the differential in the rates from the Arm is so great that it is seen as being worth the risk. If it were at least 1% this would make the ARM more desirable, however if it were only about .25% you would be better off getting the Fixed Rate.
How will I know how much my rate jump will be?
To play this game it is imperative that you know how the rate hike will affect your payments if for some reason you cannot get out of the loan. It is easy to look at it like this in the beginning, you are to assume that the rate will not change at all. This period will be five years. Now at the end of this time you have to assume that the rates are going to go through the roof. What you are really searching for here is best and worst case scenarios.
To perform a proper analysis you need five important pieces of information.
- The recent value of the index your loan is tied to
- The margin that is used to determine the rate for that particular index
- The rate change frequency
- The cap at which the rate is set. How high can it possibly go.
- What is the maximum rate you will be charged over the life time of the loan
In the best case scenario which means that there is no change in the interest rate the ARM will only adjust to equal the sum of the value of the index + the margin. This happens in stages, for instance if you have a loan that is a 5/1, this means you have a fixed rate only for the first five years and the adjustments happen every year thereafter. If you do the math you will find that with a cap of 2% you will find that what started out as a 5% interest will eventually will go up to 8% and no higher.
The worst case is that the mortgage has no rate adjustment cap at all and the first rate hike would be to its fullest, this is generally a12% rate hike. If there were a cap of 2% it would only get to 12% in the 97month of payments.
This information is crucial in the beginning so that you are fully aware of the possible ramifications of choosing this type of loan. A lot of borrowers stop at the first set of calculations not bothering with the long-term effects. Knowing what could happen and when give you greater freedom to plan for the future.
You can get all the information needed to perform you own calculations from a loan officer. But be warned they may feign ignorance when it comes to the question of index value. Do no be dismayed because it is often best if you get the information from some other source. So not ever be satisfied with the answer “the Treasury bill” since there are several types of these be persistent enough to get a description that will enable you to identify it for yourself.
About Interest Rate Calculators
You can find several interest rate calculators online that will allow you to make all of the necessary computations once you have the figures you need. this will allow you to actually play around with different mortgage loan amounts to get an idea of what would work best for you. Below are links for two such calculators that have ways of determining several payment factors for you.
- The monthly payment calculator that shows the adjustable rate without negative amortization can be found at http://www.mtgprofessor.com/Calculators/Calculator7b.html,
- Another monthly payment calculator that shows the same information only this time with negative amortization is at http://www.mtgprofessor.com/Calculators/Calculator7c.html
- To do a comparison of fixed Vs adjustable without negative amortization, go to http://www.mtgprofessor.com/Calculators/Calculator9a.html
- And to add in the negative amortization go to http://www.mtgprofessor.com/Calculators/Calculator9b.html
You now have all you need to figure out what your next step should be. Single mothers need to be well informed before making a decision that will affect their lives for this length of time. They have to be careful that the decision is sound and the payments are doable over that long span of time.
The adjustable rate mortgage is not normally a good choice for first time buyers because of the risks involved. And unless you are sure you are going to be working in a recession proof field, it may be that you should consider the fixed rate mortgage. That being said you can make up your own mind. Look at the entire set of variables in dept before you leap into something that could be devastating in your financial future.
Finding a home loan is the first step to true independence and forward mobility. Home ownership has long been the “American Dream” by making informed decisions and planning wisely you can secure this dream for you and yours. No the risks, make the choice and enjoy your new home.