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August 17, 2000, Revised March 18,
2003
Borrowers trying to
decide whether they should select an adjustable-rate mortgage (ARM) or a
fixed-rate mortgage (FRM) based on the lowest after-tax interest cost can now
use calculators 9a and 9b. These cover ARMs that don't allow negative
amortization, and ARMs that do, respectively. They do not show mortgage
payments. If you are concerned about whether or not you can deal with the
mortgage payments on an ARM if interest rates increase, you should use
calculator 7b or 7c.
We call the time-adjusted measure used
for the comparison "mortgage interest cost." It is calculated in the
same way as the APR except that the APR assumes that the loan runs to term for
all borrowers, which makes it a treacherous guide. (See Does
the APR Help?)
Interest cost is measured over the
individual borrower's time horizon. Since most borrowers aren't exactly sure
about how long they will be in their houses, we ask the user for their best
guess, and also for the periods they view as the earliest and latest they might
move. This allows the user to see whether and how differences in their length of
tenure affect the cost comparison.
A second way in which interest cost
differs from the APR is that interest cost may be measured after taxes at the
individual borrower's own tax rate. The APR is always measured before taxes.
A third way in which interest cost
differs from the APR is that the cost items included in interest cost may be
more or less inclusive than those included in the APR. The APR is rife with
inconsistencies and ambiguities with regard to exactly what is and what is not
covered. Interest cost provides a list of cost items but the user can add or
delete items as seems appropriate. For purposes of comparing two mortgages, cost
items expressed as a percent of the loan amount that are identical for the two
mortgages can be omitted because they will not affect the comparison. Cost items
that are identical dollar amounts also can be omitted if the loan amounts are
the same.
We ask for the down payment because
mortgage insurance premiums are a cost item and premiums are higher on ARMs than
on FRMs. If you make a down payment of 20% or more, no mortgage insurance is
required. The other cost items should be self-explanatory.
The item "Most Recent Value of
Interest Rate Index" requires you to identify the interest rate index
that your particular ARM contract uses. The rate on every ARM is tied to
movements in a specific interest rate series that is published periodically.
About a dozen different series are used, and the one that applies to your ARM is
shown in the ARM disclosure form that was given to you when you took out the
loan. If you don't have it, call up the servicing agent to whom you send your
payments and ask for the information. The table will provide the most
recent value of the index automatically, but it may not be up to date.
Current values are available at the following sites.
http://www.federalreserve.gov/releases/,
http://www.hsh.com/indices/11cof00s.html,
http://www.bankrate.com/brm/ratehm.asp,
http://www.nfsn.com/library/mta.htm,
http://www.mortgage-x.com/general/mortgage_indexes.asp,
http://nt.mortgage101.com/partner-scripts/1196.asp?p=low-rate-mortgages
The "Margin" is the amount
that is added to the interest rate index to determine your ARM rate. It usually
ranges from 2.5 to 3%. The margin that applies to your ARM is shown in the ARM
disclosure form and on the mortgage note. If you can't find it, call up the
servicing agent to whom you send your payments and ask for it.
The "Number of Months to First
Adjustment" is the period for which the initial rate holds. The
"Maximum Interest Rate Change on First Rate Adjustment" is the maximum
amount by which the interest rate can change on the first rate adjustment date.
ARMs on which the initial rate holds for 5 years or longer but which then adjust
the rate every year are likely to have a larger cap at the first rate adjustment
than on subsequent adjustments. Hence, provision is made in the calculator for
two caps, one applicable to the first adjustment and the other applicable to all
later adjustments.
For example, a new "7/1 ARM with
caps of 5 and 2" is one where the initial rate holds for 7 years, the first
rate adjustment cannot exceed 5%, rate adjustments thereafter occur every year
and cannot exceed 2%. Hence, you would enter 84 and 5 under "First Rate
Adjustment" and 12 and 2 under "Second Rate Adjustment".
The maximum and minimum interest rates
apply over the entire life of the mortgage. They are in your note and ARM
disclosure form.
You can select as many as 6 assumptions
about future interest rates. You should always look at the Stable Index scenario
as your benchmark, because it tells you what would happen if interest rates
remain the same through the life of your loan. More precisely, it assumes
stability in the specific index used by your ARM, but the interest rate indexes
all tend more or less to move together.
The Worst Case scenario is also worth
looking at because it is exactly what it says. This scenario assumes that rates
increase by as much as the contract allows. If you can deal with the payment
increases associated with this scenario, you are safe with this ARM.
Neither the no-change nor the worst-case
scenarios are likely to materialize, so the calculator allows you to design
other scenarios that you or your guru believe might be more likely. You can
assume that the index rate trends either up or down by amounts selected by you,
or fluctuates over periods and by amounts that are selected by you.
Copyright Jack Guttentag 2003
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