Do you have an Adjustable Rate Mortgage?

Over the last several years many people chose an Adjustable Rate Mortgage (ARM) for financing their home. Most ARMs fall into one of three categories. An ARM in its simplest form is a mortgage that is open to a rate change every 1, 3 or 5 years. In this scenario the borrower elects to pay a lower interest rate on his mortgage in exchange for taking on the liability of future interest rate movements.

In a fixed rate mortgage the lender commits to an interest rate for the entire term of the mortgage. The lender charges an interest rate that is high enough to cover any increase in their costs of funds during the mortgage’s term. When a borrower elects to use an ARM he agrees to give the lender a guaranteed profit over their costs of funds. If rates go up, the borrower pays more. If rates go down then the borrower pays less.

The second type of ARM is a hybrid adjustable. Here there is an initial term of 3, 5, 7 or 10 years where the rate remains the same. At the end of this initial period the mortgage becomes a 1-year ARM. At this point the rate will change every year as the financial markets move.

Finally, there is the pay option ARM. Under this program in addition to the rate changing periodically the borrower has the option of selecting, with certain limitations, the dollar amount the payment should be for a particular month. The borrower can elect to pay as much principal he wants, pay no principal just the interest due for the month or pay less than the interest charge for the month effectively borrowing additional money.

Due to all the negative press directed at the subprime mortgage market and their ARM programs everyone that currently has an ARM is panicking. We are warned about the number of hybrid ARMS that are resetting this year or will reset in the next year or two. This is encouraging anyone who currently has an ARM to immediately refinance into a fixed rate mortgage regardless of the cost or their personal financial situation.

If you are in an ARM you need to understand the details of your mortgage before doing anything else. You could very easily be in the proper mortgage and not even realize it. Refinancing may be an expense that you don’t need to incur right now.

One thing that all ARMs have in common is that there is a formula that specifies what the rate will become at a rate change. Another common attribute of all ARMS is that there are limitations (caps and floors) that dictate the range you mortgage can rest to each time it adjusts. Before doing anything you need to find these details.

At your closing you signed numerous papers and you were given a copy of everything you signed. Hopefully you kept those papers. Go back and look for a document labeled “Note”. The 2 most important documents you signed are the “Mortgage” and the “Note”.

The mortgage is the actual lien that is filed against the property. There are no details in this document regarding interest rate, mortgage payment, term etc. All that information is contained in the “Note”. The “Note” specifics the details of how you have agreed to pay back the money you borrowed from the lender. It’s here that you will find the formula used in calculating your interest rate and the limits of the change.

You can’t find those papers. Now what do you do? The servicer, that is the company you make out your mortgage payment to each month, has a copy of the “Note” in their files. Many even provide access to your closing documents through their website. The servicer will supply you with a copy of the “Note”; all you need to do is request it.

The formula to calculate you new interest rate will consist of an index rate and a margin that are added together and give you your new interest rate. The index rate is a rate reflects market conditions, it is an interest rate that the lender doesn’t have influence over.

Typically it will be the yield on 1-year Treasury Bills or on the 1-year LIBOR. The 1-year T-Bill is the current rate the US government needs to pay an investor to borrow money for 1 year. LIBOR (the London Inter-Bank Offer Rate) is a rate that reflects what banks need to pay other banks when they borrow money for a period of one year any where in the world.

The margin is a constant that when added to the index rate yields the new interest rate on your mortgage. What that calculates to needs to be considered before rushing into a refinance.

For example, if your mortgage was resetting today to a rate of 1-year LIBOR plus 2.25% you rate for the upcoming year will be 5.50% (3.231% plus 2.25% equals 5.481% which is rounded up to the nearest 0.125% making the rate 5.50%). This is assuming that the rate cap specified in the “Note” isn’t crossed. If the rate cap yields a rate lower than 5.50%, then that is the rate you will be adjusting to.

With fixed rate mortgages today costing 6.50% should you be rushing to refinance into a fixed rate? You still may elect to refinance for other reasons but you certainly shouldn’t be doing it because of the new rate.

When you originally closed on this mortgage you had made the decision that it was the best product for your situation. Don’t let the news media lead you into a refinance when in fact this still may be the cheapest financing available. Make your decision based on the specifics of your mortgage and how it fits into your current financial situation. Don’t feel forced to refinance because it appears to “be the thing to do”.

Is the Time Right to Buy?

The decision to buy a home is derived from 2 major considerations; your analysis of the housing market & your analysis of your personal financial situation. Both considerations need to conclude that buying now is right for you. We’re going to begin by examining your current status and what your goals are for the future.

How long do you plan on living in this community?
This is the most general, yet the most relevant question you need to ask yourself. If you don’t see yourself and your family, if you have one, staying in the area for more than 3 years, then buying a home is probably not a good idea. The transaction costs in the buying and the selling of a home are large. If you plan on moving within a few years, any property you purchase will need to appreciate at least enough to cover your transaction costs just to break even. Real estate investments can yield that kind of appreciation but it's probably not a smart decision to take that gamble unless you are convinced the market has bottomed out and appreciation is going to kick in immediately.

What’s the status of your current rental?
Examine the remaining term of your lease. Are you paying an attractive rent right now? Will you need to move soon for any reason? You may need to move because the apartment is too small for your growing family, you’re facing a substantial rent increase, the landlord is not offering you a renewal lease, etc. The plausibility of staying in your current apartment will be a major influence in the decision.

What’s your income situation?
How secure are you in your job and what is the potential for salary increases? Obviously, if you are going to take on the financial responsibility of owning a home, you want to feel comfortable knowing that you will be able to meet the expenses.

How much have you saved?
Purchasing a house today requires you to come up with a down payment and cover your closing costs. The amount of money you have saved will determine that you have the assets to make the purchase and will be a factor in deciding the maximum price you can pay for your home.

What’s your track record with utilizing debt?
We are all aware how important your credit history is when applying for a mortgage. In today’s lending environment any payment history that’s less than perfect will impact the cost of financing. Looking beyond the payback history, you now also need to take a closer look your balances. Are your credit card balances increasing or decreasing over time? If they’re increasing, that’s a sign that you are spending more than you are making and you will need to correct this before going any further. If you are paying down debt, you may want to get closer to the goal of zero balances before buying your home.

Are you prepared to make a lifestyle change?
Living in a home is different than living in an apartment. You are now responsible for all the maintenance and repairs, not your landlord. Some people enjoy working on their home. They see it as a hobby and get personal satisfaction in it. Others have no interest in this and see it as an infringement on their lifestyle. Owning a home is not for everybody. You need to be sure that this is a lifestyle you are going to be happy with.

Once you are comfortable knowing that owning a home is a goal that you can afford and look forward to the new lifestyle, you can begin to study the current housing market. Everywhere you look you are going to find scary housing news. The housing market is dealing with a perfect storm. Inventory is at an all time high, prices are dropping, foreclosures are up, mortgage defaults are up, mortgage options are extremely limited, credit standards have never been tighter and utility costs are at a record high. Why would anyone consider buying a house under these conditions?

The first thing to be considered is that a home not only an investment but it also serves as a place to live. Its primary purpose is shelter for the family and we can’t lose sight of that. There is a cost for shelter that’s paid by everyone; it’s either paid as a mortgage payment or in rent. Real estate is a long-term investment. That’s a concept that was lost during the housing boom cycle. Historically, housing appreciation has been measured in decades, not weeks. During the overheated housing market people expected prices to go up almost daily. Reality finally set in and prices are correcting from their peak, but housing prices are still higher than they were 10 years ago. They’re just not as high as they were 2 years ago.

The high inventory of houses on the market allows today’s buyer to find the best house to fit their needs. No house is ever perfect but you can come a lot closer when there is a larger inventory to choose from.

The declining price of houses is a double-edged sword. Houses are a bargain today compared to 2-years ago but will they be even cheaper tomorrow? No one can answer that question. What needs to be done is to take all the factors of the marketplace, add your personal considerations and come to a logical conclusion. There are no guarantees that you are going to make the right decision, only time will determine that. All you can do is give it your best shot.

A good place to start is to compare the monthly expense of carrying a home to paying rent for a similar space. As the cost of ownership comes closer to the cost of renting in the same community, the price of a home in that community is reaching its lowest point. Owning a home provides shelter and an opportunity for property appreciation. The increase in carry cost from a rental to being an owner is the premium the market is demanding for the potential appreciation.

Any seasoned investor knows you can’t expect to buy anything at its absolute lowest point. You look to buy as low as possible. You only know the lowest point has been reached when prices begin to rise and then it’s too late to buy at the bottom.

Mortgage rates are historically low and no one can predict when and how fast they will rise. So, deciding when to buy, you need to consider what’s happening with the cost of money. The increase in financing costs will offset a portion, if not all of the saving, in a lower purchase price.

If housing prices stabilize or begin to increase at the same time mortgage rates go up, you may find yourself unable to afford the house you want to buy and will be forced to settle on a lower priced home.

From an investor’s prospective, the best buying opportunities become available when buyers disappear. In our corner of the housing market we are closer to the bottom than the media is leading you to believe. Anyone who had the confidence (or luck) to purchase a home in the early eighties when we were facing double-digit inflation, mortgage rates at 18% and OPEC dominance in fuel costs saw their houses double in value in a short period of time.

If it is the right time in your life to become a homeowner, don’t let the pessimism in today’s market stop you. Find the house you want, buy it, raise your family in it and ignore today’s gloom and doom. Years from now, when it’s time to move, you’ll sell the house at a profit.