|
December 4, 2000
"I�m a first-time home buyer shopping for my first mortgage and find myself confused about what I�m
shopping for. I understand interest rates (I think), but I also hear about
fully-indexed interest rates, points, rebates, origination fees, junk fees,
maximum interest rates, and margins. Please sort this out in a way I can
understand."
I'll try.
Interest rate
is the number that is multiplied by the loan balance to get the interest payment
due the lender. The rate quoted on a mortgage is an annual rate, but it is
applied monthly. On a 6% mortgage with a $100,000 balance, for example, the
monthly interest due is .005 times $100,000, or $500.
On a fixed-rate mortgage (FRM), the
interest rate is preset for the life of the loan. On an adjustable rate mortgage
(ARM), the rate is preset for an initial period, ranging from 1 month to 10
years, and then can change.
Points
are upfront charges expressed as a percent of the loan amount. Two points amount
to 2% of the loan.
Points are related to the interest rate.
If a lender offers a 30-year FRM at 8% and zero points, for example, he might
charge 1.75 points for a 7.5% loan.
Rebates
are points paid by (rather than to) the lender for high-rate loans. The lender
who charges 1.75 points for a 7.50% loan, for example, might rebate 2 points for
a 9% loan. The 2 points would be available to defray the borrower�s settlement
costs.
Origination fees are
points in disguise. Some lenders charge origination fees because reporting
services and newspapers show rates and points but not origination fees. The
lender who charges 1 point and a 1% origination fee looks cheaper than the
lender who charges 2 points and no origination fee. To the borrower, points and
origination fees are the same.
"Junk fees"
is a nasty term sometimes used to describe all other upfront charges by the
lender or mortgage broker. Junk fees are expressed in dollars rather than as a
percent of the loan. On my web site I have a long list of items that some
lenders may charge for, but for the borrower shopping the market, only the total
matters.
In sum, the price of a mortgage
has three components: interest rate, total upfront charges expressed as a
percent of the loan, and total upfront charges expressed in dollars.
ARM shoppers who confidently
expect to be out of the house before the end of the initial rate period need
concern themselves only with the initial rate. But ARM shoppers who are
uncertain about how long they will be in their house should have two indicators
of what might happen to the ARM rate after the initial rate period ends.
The fully indexed rate (FIR)
tells them where the ARM rate will go in a stable interest rate environment. The
maximum rate tells them where the ARM rate will go in a rising rate
environment.
The fully indexed rate (FIR) is
the sum of the interest rate index used by the ARM and the fixed margin that
is added to it. Both the index and the margin are specified in the ARM contract.
For example, many ARMs use the Treasury
one-year index, which had a value on Dec. 6, 2000 of 5.72%. On that day, an ARM
that uses this index and has a margin of 3% had a FIR of 8.72%. At the end of
the initial rate period, assuming the interest rate index does not change from
its initial value, the rate on the ARM will move toward the FIR.
The maximum rate is the highest
rate permitted by the ARM contract. Even if interest rates explode, the ARM rate
cannot exceed this maximum.
It is also useful for an ARM shopper to
know whether rate adjustments at the end of the initial rate period will be
abrupt or gradual. This depends on how frequently rates are adjusted, and on the
cap (if any) on how large a rate adjustment can be. Detailed examples are
provided in Information
Needed to Evaluate an ARM.
Copyright Jack Guttentag 2002
| 
