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Keep an eye on your ARM

There are millions of mortgages out there that are set to adjust in the next few years, and every person who has one should take some time and discuss with a mortgage professional what might happen when that day comes.

Chances are that your home mortgage is your largest financial commitment, and a double-digit portion of your income may be going to pay it off every month. If you have an adjustable mortgage you need to watch it as carefully as you would your other investments, because interest rates on adjustables have risen dramatically recently, and your mortgage could really take a hit when it does.

Of course, until that time comes you will not know exactly what could happen, but let’s look at an example that came across my desk in recent weeks. Every loan can be different in the way it is written, but there are a few key indicators that you and your loan officer can review to see how yours might behave.

Recently I had a couple come in to review their loan, which they had gotten from another lender about four years ago. It was in the amount of $450,000 with a fixed rate for five years at 4.75 percent. Although they had one year to go they felt they would be staying in the house for some time and were wondering “what if.”

I went through their loan documents and we noted that the loan was tied to the one-year Treasury bill plus a margin of 2.75 percent. This means when it’s time to adjust the rate, the lender will look up the one-year T-Bill rate and add 2.75 percent to it. After the fifth anniversary of the loan, the rate will adjust once a year.

Their loan did have interest rate caps, and was set up as a “5/2/5” program. This means that the rate cannot go up more than 5 percent in the first adjustment (in this case to 9.75 percent) or 2 percent each year thereafter, with a lifetime cap of 9.75 percent. If by chance the loan went up to 9.75 percent the first time it adjusted, it would have hit its lifetime cap.

Also, when the loan adjusts the payments are recalculated to pay off the balance over the remaining life of the loan. After five years, for example, the lender would use a 25-year amortization.

First, we needed to calculate the remaining balance at the end of five years. In this case that would be $434,617. Next we checked the one-year T-bill yield (it was 5.17 percent that day). To calculate what the payment increase would be if the conditions were the same in two years, we added the margin to the T-bill yield and that gave us a rate of 7.92 percent. Ouch!

Next we took the projected remaining balance and calculated what their new payment might be and came up with a principal and interest payment of $3,331.44. Currently their principal and interest payment was $2,477.82, so they were facing a potential monthly payment increase of over $850.

And that, of course, is assuming that the T-bill is still yielding 5.17 percent a year from now. If it went up to say 6 percent, the rate on their mortgage would be 8.75 percent. Needless to say this was rather a shocker to my clients and they decided perhaps it was appropriate to explore their options.

We looked at several options and finally decided on a 30-year fixed rate to refinance at 6.125 percent, which raised their payments to $2,641 a month, or an increase of $307 per month. Although there were closing costs on the deal, the borrowers will likely save tens of thousands of dollars in the long run.

If your loan has “potential negative amortization” you need to be very alert when your payments adjust. What this means is that the increase on your monthly payment may be limited but the amount you really pay in interest is not. So, your payment may only go up, say $100, while the higher interest you are racking up may actually be double that. The balance gets added onto your loan balance, and then you pay interest on that. I recently had a client whose loan had gone into negative amortization and they were racking up nearly double what their monthly payment was in negative amortization.

Every deal is different though, and there are no rules of thumb here except one, and that is ” read your loan documents carefully.

Chris Neuswanger is a loan officer and may be reached at Macro Financial Group in Avon at 970-748-0342. His e-mail is chris.n@macrofinancial.com. He welcomes mortgage related inquiries from readers.

Vail, Clorado


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