Posts Tagged ‘Examples’

5/1 Hybrid Adjustable-Rate Mortgage (5/1 Hybrid ARM) Examples

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What Is a 5/1 Hybrid Adjustable-Rate Mortgage (5/1 ARM)?

A 5/1 hybrid adjustable-rate mortgage (5/1 ARM) begins with an initial five-year fixed interest rate period, followed by a rate that adjusts on an annual basis. The “5” in the term refers to the number of years with a fixed rate, and the “1” refers to how often the rate adjusts after that (once per year). As such, monthly payments can go up—sometimes dramatically—after five years.

Key Takeaways

  • 5/1 hybrid adjustable-rate mortgages (ARMs) offer an introductory fixed rate for five years, after which the interest rate adjusts annually.
  • When ARMs adjust, interest rates change based on their marginal rates and the indexes to which they’re tied.
  • Homeowners generally enjoy lower mortgage payments during the introductory period.
  • A fixed-rate mortgage may be preferable for homeowners who prefer predictability with their mortgage payments and interest costs.

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How a Hybrid Adjustable-Rate Mortgage (Such as a 5/1 Hybrid ARM) Works

The 5/1 hybrid ARM may be the most popular type of adjustable-rate mortgage, but it’s not the only option. There are 3/1, 7/1, and 10/1 ARMs as well. These loans offer an introductory fixed rate for three, seven, or 10 years, respectively, after which they adjust annually.

Also known as a five-year fixed-period ARM or a five-year ARM, this mortgage features an interest rate that adjusts according to an index plus a margin. Hybrid ARMs are very popular with consumers, as they may feature an initial interest rate significantly lower than a traditional fixed-rate mortgage. Most lenders offer at least one version of such hybrid ARMs; of these loans, the 5/1 hybrid ARM is especially popular.

Other ARM structures exist, such as the 5/5 and 5/6 ARMs, which also feature a five-year introductory period followed by a rate adjustment every five years or every six months, respectively. Notably, 15/15 ARMs adjust once after 15 years and then remain fixed for the remainder of the loan. Less common are 2/28 and 3/27 ARMs. With the former, the fixed interest rate applies for only the first two years, followed by 28 years of adjustable rates; with the latter, the fixed rate is for three years, with adjustments in each of the following 27 years. Some of these loans adjust every six months rather than annually.

Hybrid ARMs have a fixed interest rate for a set period of years, followed by an extended period during which rates are adjustable.

Example of a 5/1 Hybrid ARM

Interest rates change based on their marginal rates when ARMs adjust along with the indexes to which they’re tied. If a 5/1 hybrid ARM has a 3% margin and the index is 3%, then it adjusts to 6%.

But the extent to which the fully indexed interest rate on a 5/1 hybrid ARM can adjust is often limited by an interest rate cap structure. The fully indexed interest rate can be tied to several different indexes, and while this number varies, the margin is fixed for the life of the loan.

A borrower can save a significant sum on their monthly payments with a 5/1 hybrid ARM. Assuming a home purchase price of $300,000 with a 20% down payment ($60,000), a borrower with very good/excellent credit can save 50 to 150 basis points on a loan and more than $100 per month in payments on their $240,000 loan. Of course, that rate could rise, so borrowers should anticipate a rise in their monthly payment, be prepared to sell their home when their rate goes up, or be ready to refinance.

Note

When refinancing from an ARM to a fixed-rate mortgage, it’s important to consider the new loan term carefully, as it could have a significant impact on how much you pay in total interest to own the home.

Advantages and Disadvantages of a 5/1 Hybrid ARM

In most cases, ARMs offer lower introductory rates than traditional mortgages with fixed interest rates. These loans can be ideal for buyers who plan to live in their homes for only a short period of time and sell before the end of the introductory period. The 5/1 hybrid ARM also works well for buyers who plan to refinance before the introductory rate expires. That said, hybrid ARMs like the 5/1 tend to have a higher interest rate than standard ARMs.

Pros

  • Lower introductory rates than traditional fixed-interest mortgages

  • Interest rates possibly drop before the mortgage adjusts, resulting in lower payments

  • Good for buyers who will live in their homes for short periods of time

Cons

  • Higher interest rates than standard adjustable-rate mortgages (ARMs)

  • When mortgage adjusts, interest rates probably rise

  • Could be trapped in unaffordable rate hikes due to personal issues or market forces

There’s also a chance that the interest rate might decrease, lowering the borrower’s monthly payments when it adjusts. But in many cases, the rate will rise, increasing the borrower’s monthly payments.

If a borrower takes out an ARM with the intention of getting out of the mortgage by selling or refinancing before the rate resets, then personal finances or market forces might trap them in the loan, potentially subjecting them to a rate hike that they can’t afford. Consumers considering an ARM should educate themselves on how they work.

5/1 Hybrid ARM vs. Fixed-Rate Mortgage

A 5/1 hybrid ARM may be a good mortgage option for some homebuyers. But for others, a fixed-rate mortgage may be more appropriate. A fixed-rate mortgage has one set interest rate for the life of the loan. The rate is not tied to an underlying benchmark or index rate and doesn’t change; the interest rate charged on the first payment is the same interest that applies to the final payment.

A fixed-rate mortgage could yield advantages for a certain type of homebuyer. If you’re interested in predictability and stability with mortgage rates, for example, then you might lean toward a fixed-rate loan instead of a 5/1 hybrid ARM. Comparing them side by side can make it easier to decide on a mortgage option.

5/1 Hybrid ARM vs. Fixed-Rate Mortgage
5/1 Hybrid ARM Fixed-Rate Mortgage
The loan’s interest rate adjusts after the initial fixed-rate period. The interest rate remains the same for the life of the loan.
Monthly payments could increase or decrease as the rate adjusts. Monthly payments are predictable and do not fluctuate due to changing rates.
More difficult to estimate the total cost of borrowing as rates adjust. Homebuyers can estimate their total cost of borrowing over the life of the loan.

Is a 5/1 Hybrid ARM a Good Idea?

A 5/1 hybrid ARM could be a good choice for homebuyers who don’t plan to stay in the home long term or who are confident in their ability to refinance to a new loan before the rate adjusts. If interest rates remain low and adjustments to the index rate are relatively minor, then a 5/1 hybrid ARM could save you more money over time compared to a fixed-rate mortgage.

But it’s important to consider how feasible refinancing is and where interest rates might be when you’re ready to move to a new loan. If interest rates rise, then refinancing to a new fixed-rate loan or even to a new ARM may not yield that much in interest savings.

If you don’t plan to refinance and don’t plan to move, then it’s important to consider how realistic that might be for your budget if a rate adjustment substantially increases your monthly payment. If the payment becomes too much for your budget to handle, you may be forced into a situation where you have to sell the property or refinance. And in a worst-case scenario, you could end up facing foreclosure if you default on the loan payments.

If you’re interested in refinancing from a 5/1 hybrid ARM to a fixed-rate mortgage, consider the interest rates for which you’re likely to qualify, based on your credit history and income, to determine if it’s worthwhile.

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3-2-1 Buydown Mortgage

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A 3-2-1 buydown mortgage is a type of loan that starts out with a low interest rate and rises over the next several years until it reaches its permanent rate.

Here is how 3-2-1 buydown mortgages work and how to decide if one is right for you.

Key Takeaways

  • With a 3-2-1 buydown mortgage, the borrower pays a lower interest rate over the first three years in return for an up-front payment to the lender.
  • The interest rate is reduced by 3% in the first year, 2% in the second year, and 1% in the third year. For example, a 5% mortgage would charge just 2% in year one.
  • After the buydown period ends, the lender will charge the full interest rate for the remainder of the mortgage.
  • Buydowns are often used by sellers, including home builders, as an incentive to help buyers afford a property.

How 3-2-1 Buydown Mortgages Work

A buydown is a mortgage-financing technique that allows a homebuyer to obtain a lower interest rate for at least the first few years of the loan, or possibly its entire life, in return for an extra up-front payment. It is similar to the practice of buying discount points on a mortgage in return for a lower interest rate.

Either the homebuyer/borrower or the home seller may cover the costs of the buydown.

In general, 3-2-1 buydown loans are available only for primary and secondary homes, not for investment properties. The 3-2-1 buydown is also not available as part of an adjustable-rate mortgage (ARM) with an initial period of fewer than five years.

In a 3-2-1 buydown mortgage, the loan’s interest rate is lowered by 3% in the first year, 2% in the second year, and 1% in the third year. The permanent interest rate then kicks in for the remaining term of the loan. In a 2-1 buydown, by contrast, the rate is lowered by 2% during the first year, 1% in the second year, and then goes to the permanent rate after the buydown period ends.

Pros and Cons of a 3-2-1 Buydown Mortgage

A 3-2-1 buydown mortgage can be an attractive option for homebuyers who have some extra cash available at the outset of the loan, as well as for home sellers who need to offer an incentive to facilitate the sale of their homes.

It also can be advantageous for borrowers who expect to have a higher income in future years. Over the first three years of lower monthly payments, the borrower can also set aside cash for other expenses, such as home repairs or remodeling.

When the loan finally resets to its permanent interest rate, borrowers have the certainty of knowing what their payments will be for years to come, which can be useful for budgeting. A fixed-rate 3-2-1 buydown mortgage is less risky than the above-mentioned ARM or a variable-rate mortgage, where rising interest rates could mean higher monthly payments in the future.

A potential downside of a 3-2-1 buydown mortgage is that it may lull the borrower into buying a more expensive home than they will be able to afford once their loan reaches its full interest rate. Borrowers who assume that their income will rise in line with future payments could find themselves in too deep if their income fails to keep pace.

Examples of Subsidized 3-2-1 Buydown Mortgages

In many situations, the up-front costs of a 3-2-1 buydown will be covered by someone other than the homebuyer. For example, a seller might be willing to pay for one to seal the deal. In other cases, a company moving an employee to a new city might cover the buydown cost to ease the expense of relocation. More commonly, real estate developers will offer buydowns as incentives to potential buyers of newly built homes.

Is a 3-2-1 Buydown Mortgage Right for Me?

If you will need to pay for the buydown on your own, then the key question to ask yourself is whether paying the cash up front is worth the several years of lower payments that you’ll receive in return. You might, for example, have other uses for that money, such as investing it or using it to pay off other debts with higher interest rates, like credit cards or car loans. If you have the cash to spare and don’t need it for anything else, then a 3-2-1 buydown mortgage could make sense.

As mentioned earlier, however, it can be risky to go with a 3-2-1 buydown mortgage on the assumption that your income will rise sufficiently over the next three years so that you’ll be able to afford the mortgage payments when they reach their maximum. For that reason, you’ll also want to consider how secure your job is and whether unforeseen circumstances could come along that would make those payments unmanageable.

The question is easier to answer when someone else is footing the bill for the buydown. In that case, you’ll still want to ask yourself whether those maximum monthly payments will be affordable when the time comes—or whether the enticingly low initial rates could be leading you to buy a more expensive home and take on a bigger mortgage than makes sense financially. You’ll also want to make sure that the home is fairly priced in the first place and that the seller isn’t padding the price to cover its buydown costs.

These are questions that only you can answer, but you may find this Investopedia article on How Much Mortgage Can You Afford? helpful.

FAQs

What Is a 3-2-1 Buydown Mortgage?

A 3-2-1 buydown mortgage is a type of loan that charges lower interest rates for the first three years. In the first year, the interest rate is 3% less; in the second year, it’s 2% less; and in the third year, it’s 1% less. After that, the borrower pays the full interest rate for the remainder of the mortgage. For example, with a 5%, 30-year mortgage, the interest rate would be 2% in year one, 3% in year two, 4% in year three, and 5% for the remaining 27 years.

What Does a 3-2-1 Buydown Mortgage Cost?

The cost of a 3-2-1 buydown mortgage can vary from lender to lender. Generally, the lender will at least want the cost to cover the income that it is forgoing by not charging the borrower the full interest rate from the start.

Who Pays for a 3-2-1 Buydown Mortgage?

Either the buyer/borrower or the home seller can pay for a buydown mortgage. In the case of a 3-2-1 buydown mortgage, it is often a seller, such as a home builder, who will cover the cost as an incentive to potential buyers. Employers will sometimes pay for a buydown if they are relocating an employee to another area and want to ease the financial burden.

Is a 3-2-1 Buydown Mortgage a Good Deal?

A 3-2-1 buydown mortgage can be a good deal for the homebuyer, particularly if someone else, such as the seller, is paying for it. However, buyers need to be reasonably certain that they’ll be able to afford their mortgage payments once the full interest rate kicks in. Otherwise, they could find themselves stretched too thin—and, in a worst-case scenario, even lose their homes.

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Autonomous Expenditure

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Accretive: Definition and Examples in Business and Finance

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What is an Autonomous Expenditure?

An autonomous expenditure describes the components of an economy’s aggregate expenditure that are not impacted by that same economy’s real level of income. This type of spending is considered automatic and necessary, whether occurring at the government level or the individual level. The classical economic theory states that any rise in autonomous expenditures will create at least an equivalent rise in aggregate output, such as GDP, if not a greater increase.

Understanding Autonomous Expenditure

An autonomous expenditure obligation must be met regardless of income. It is considered independent in nature, as the need does not vary with incomes. Often, these expenses are associated with the ability to maintain a state of autonomy. Autonomy, in regard to nations, includes the ability to be self-governing. For individuals, it refers to the ability to function within a certain level of societally acceptable independence.

To be considered an autonomous expenditure, the spending must generally be deemed necessary to maintain a base level of function or, in an individual sense, survival. Often, these expenses do not vary regardless of personal disposable income or national income. Autonomous expenditure is tied to autonomous consumption, including all of the financial obligations required to maintain a basic standard of living. All expenses beyond these are considered part of induced consumption, which is affected by changes in disposable income.

In cases in which personal income is insufficient, autonomous expenses still must be paid. These needs can be met through the use of personal savings, consumer borrowing mechanisms such as loans and credit cards, or various social services.

Key Takeaways

  • Autonomous expenditures are expenditures that are necessary and made by a government, regardless of the level of income in an economy.
  • Most government spending is considered autonomous expenditure because it is necessary to run a nation.
  • Autonomous expenditures are related to autonomous consumption because they are necessary to maintain a basic standard of living.
  • External factors, such as interest rates and trade policies, affect autonomous expenditures.

Autonomous Expenditures and Income Levels

While the obligations that qualify as autonomous expenditures do not vary, the amount of income directed toward them can. For example, in an individual sense, the need for food qualifies as an autonomous expenditure, though the need can be fulfilled in a variety of manners, ranging from the use of food stamps to eating every meal at a five-star restaurant. Even though income level may affect how the need is met, the need itself does not change.

Governments and Autonomous Expenditures

The vast majority of government spending qualifies as autonomous expenditures. This is due to the fact that the spending often relates strongly to the efficient running of a nation, making some of the expenditures required in order to maintain minimum standards.

Factors Affecting Autonomous Expenditures

Technically, autonomous expenditures are not affected by external factors. In reality, however, several factors can affect autonomous expenditures. For example, interest rates have a significant effect on consumption in an economy. High interest rates can tamp down on consumption while low interest rates can spur it. In turn, this affects spending within an economy.

Trade policies between countries can also affect autonomous expenditures made by their citizens. If a producer of cheap goods imposes duties on exports, then it would have the effect of making finished products for outside geographies more expensive. Governments can also impose controls on an individual’s autonomous expenditures through taxes. If a basic household good is taxed and no substitutes are available, then the autonomous expenditure pertaining to it may decrease.

Examples of Autonomous Expenditure

Some of the spending classes that are considered independent of income levels, which can be counted as either individual income or taxation income, are government expenditures, investments, exports, and basic living expenses such as food and shelter.

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Accrued Income: Money Earned But Not Yet Received

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Accrued Income: Money Earned But Not Yet Received

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What Is Accrued Income?

Accrued income is the money a company has earned in the ordinary course of business but has yet to be received, and for which the invoice is yet to be billed to the customer.

Mutual funds or other pooled assets that accumulate income over a period of time—but only pay shareholders once a year—are, by definition, accruing their income. Individual companies can also generate income without actually receiving it, which is the basis of the accrual accounting system.

Key Takeaways

  • Accrued income is revenue that’s been earned, but has yet to be received.
  • Both individuals and companies can receive accrued income.
  • Although it is not yet in hand, accrued income is recorded on the books when it is earned, in accordance with the accrual accounting method.

Understanding Accrued Income

Most companies use accrual accounting. It is an alternative to the cash accounting method and is necessary for companies that sell products or provide services to customers on credit. Under the U.S. generally accepted accounting principles (GAAP), accrual accounting is based on the revenue recognition principle. This principle seeks to match revenues to the period in which they were earned, rather than the period in which cash is received.

In other words, just because money has not yet been received, it does not mean that revenue has not been earned.

The matching principle also requires that revenue be recognized in the same period as the expenses that were incurred in earning that revenue. Also referred to as accrued revenue, accrued income is often used in the service industry or in cases in which customers are charged an hourly rate for work that has been completed but will be billed in a future accounting period. Accrued income is listed in the asset section of the balance sheet because it represents a future benefit to the company in the form of a future cash payout.

In 2014, the Financial Accounting Standards Board, which establishes regulations for U.S. businesses and non-profits, introduced “Accounting Standards Code Topic 606 Revenue from Contracts with Customers” to provide an industry-neutral revenue recognition model to increase financial statement comparability across companies and industries. Public companies were required to apply the new revenue recognition rules beginning in Q1 2018. The FASB also issued the following amendments to ASU No. 2014-09 to provide clarification on the guidance:

-ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606) – Deferral of the Effective Date

-ASU No. 2016-08, Revenue from Contracts with Customers (Topic 606) – Principal versus Agent Considerations (Reporting Revenue Gross Versus Net)

-ASU No. 2016-10, Revenue from Contracts with Customers(Topic 606) – Identifying Performance Obligations and Licensing

-ASU No. 2016-12, Revenue from Contracts with Customers (Topic 606) – Narrow-Scope Improvements and Practical Expedients 

Examples of Accrued Income

Assume Company A picks up trash for local communities and bills its customers $300 at the end of every six-month cycle. Even though Company A does not receive payment for six months, the company still records a $50 debit to accrued income and a $50 credit to revenue each month. The bill has not been sent out, but the work has been performed, and therefore expenses have already been incurred and revenue earned.

When cash is received for the service at the end of six months, a $300 credit in the amount of the full payment is made to accrued income, and a $300 debit is made to cash. The balance in accrued income returns to zero for that customer.

Accrued income also applies to individuals and their paychecks. The income that a worker earns usually accrues over a period of time. For example, many salaried employees are paid by their company every two weeks; they do not get paid at the end of each workday. At the end of the pay cycle, the employee is paid and the accrued amount returns to zero. If they leave the company, they still have pay that has been earned but has not yet been disbursed.

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