Posts Tagged ‘Mortgage’

3/27 Adjustable-Rate Mortgage (ARM)

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A 3/27 adjustable-rate mortgage (ARM) is a 30-year loan that carries a fixed interest rate for the first three years, then a variable rate for the remaining 27 years. Borrowers often use a 3/27 ARM as a short-term financing vehicle that they can later refinance into a mortgage with more favorable terms.

Key Takeaways

  • A 3/27 adjustable-rate mortgage (ARM) is a 30-year mortgage with a three-year fixed interest rate period.
  • The fixed interest rate is generally lower than the current rates on 30-year conventional mortgages.
  • After three years, and for the remaining 27 years of the loan, the interest rate will float based on an index, such as the yield on one-year U.S. Treasury bills.
  • Because their monthly payments can rise significantly once the interest rate adjusts, borrowers should plan carefully before taking out a 3/27 ARM to make sure it will still be affordable.

How a 3/27 ARM Works

Adjustable-rate mortgages (ARMs) are a type of home loan in which the interest rate applied to the outstanding balance varies throughout the life of the loan. With an ARM, the initial interest rate is fixed for a period of time. After that, the rate resets periodically, at yearly, semiannual, or even monthly intervals.

ARMs differ from fixed-rate mortgages, the other primary mortgage type, which charge a set rate of interest that remains the same for the entirety of the loan.

3/27 ARMs are a kind of hybrid. For the first three years, they have a fixed interest rate, which is generally lower than the current rates on 30-year conventional mortgages. But after that, and for the remaining 27 years of the loan, their interest rate will fluctuate based on a benchmark index, such as the yield on one-year U.S. Treasury bills.

The lender also adds a margin on top of the index to set the interest rate that the borrower will actually pay. The total is known as the fully indexed interest rate. This rate is often substantially higher than the initial three-year fixed interest rate, although 3/27 ARMs usually have caps on how quickly they can increase.

Typically, the interest rate on a 3/27 ARM won’t increase more than 2% per adjustment period, which can occur every six or 12 months. That means the rate can increase by two full percentage points (not 2% of the current interest rate). So, for example, the rate might go from 4% to 6% in a single adjustment period.

There might also be a life-of-the-loan cap set at 5% or more. In that case, the interest rate on a mortgage that started at 4% might go no higher than 9%, regardless of what happens with the index on which it is based.

3/27 ARM Example

Say a borrower takes out a $250,000 3/27 ARM at an initial fixed rate of 3.5%. For the first three years, their monthly mortgage payment will be $1,123.

Then let’s assume that after three years, the benchmark interest rate is 3% and the bank’s margin is 2.5%. That adds up to a fully indexed rate of 5.5%.

If the borrower still has the 3/27 ARM and hasn’t refinanced into a different mortgage, their monthly payment will now be $1,483, an increase of $360.

To avoid payment shock when the interest rate begins to adjust, borrowers with 3/27 ARMs should aim to refinance the mortgage within the first three years.

Risks of a 3/27 ARM

The most serious risks for borrowers with a 3/27 mortgage are that they won’t be able to refinance their loan before the adjustable rate kicks in and that interest rates will have shot up in the meantime. That could happen if their credit score is too low, if their home has fallen in value, or simply if market forces have caused interest rates to rise across the board.

In that event, they would be stuck with the adjustable rate, which could mean considerably higher monthly payments, as in the example above.

ARM Prepayment Penalties

Borrowers should also be aware that ARMs, including 3/27 mortgages, may carry prepayment penalties, which can make refinancing costly and defeat the purpose of taking out an ARM with the intention of switching to a different loan in a few years.

The Consumer Financial Protection Bureau (CFPB) suggests that borrowers check the lender’s Truth in Lending Act disclosure for any prepayment penalties before they sign a contract.

“Remember, many aspects of the loan are negotiable,” the CFPB notes. “Ask for a loan that does not have a prepayment penalty if that is important to you. If you don’t like the terms of a loan and the lender won’t negotiate, you can always shop around for a different lender with terms that better suit your needs.”

Is a 3/27 ARM a Good Investment?

A 3/27 ARM could be a good choice for you if you’re looking for a loan with relatively low monthly payments for the first several years. That could make buying a home more affordable if your budget is already stretched or could give you some extra cash to spend on home repairs, furnishings, or other purposes, compared with a more expensive loan.

However, you’ll want to be reasonably certain that you’ll be in a good position to refinance by the end of the initial three-year period. That means, for example, that you’ll have a strong credit score and a reliable source of income at that point.

A 3/27 ARM is not a good idea if there’s a strong possibility that you won’t be able to refinance (or sell the home) during those first three years and the new, adjustable-rate payments would be too much for you.

FAQs

What is a 3/27 adjustable-rate mortgage (ARM)?

A 3/27 adjustable-rate mortgage (ARM) charges a fixed interest rate for the first three years, followed by a variable interest rate for the remaining 27 years. Because it combines the features of a fixed-rate mortgage and an adjustable-rate mortgage, it is sometimes referred to as a hybrid ARM.

What are the advantages of a 3/27 ARM?

A 3/27 ARM is likely to have a low interest rate for the first three years. But that rate can rise substantially starting in the fourth year.

Is a 3/27 ARM right for me?

If you plan to sell the home or refinance it within the first three years, then a 3/27 ARM might make sense for you. However, look for a 3/27 ARM without any prepayment penalties. Otherwise, a prepayment penalty could make it very costly to get out of the mortgage.

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Assumable Mortgage: What It Is, How It Works, Types, Pros & Cons

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Assumable Mortgage: What It Is, How It Works, Types, Pros & Cons

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What Is an Assumable Mortgage?

An assumable mortgage is a type of financing arrangement whereby an outstanding mortgage and its terms are transferred from the current owner to a buyer. By assuming the previous owner’s remaining debt, the buyer can avoid obtaining their own mortgage. Different types of loans can qualify as assumable mortgages, though there are some special considerations to keep in mind.

Key Takeaways

  • An assumable mortgage is an arrangement in which an outstanding mortgage and its terms can be transferred from the current owner to a buyer.
  • When interest rates rise, an assumable mortgage is attractive to a buyer who takes on an existing loan with a lower rate.
  • USDA, FHA, and VA loans are assumable when certain criteria are met.
  • The buyer need not be a military member to assume a VA loan.
  • Buyers must still qualify for the mortgage to assume it.

Click Play to Learn All About Assumable Mortgages

Understanding Assumable Mortgages

Many homebuyers typically take out a mortgage from a lending institution to finance the purchase of a home or property. The contractual agreement for repaying the loan includes the interest that the borrower must pay, as well as the principal repayments to the lender.

If the homeowner decides to sell their home later, they may be able to transfer their mortgage to the homebuyer. In this case, the original mortgage taken out is assumable.

An assumable mortgage allows a homebuyer to assume the current principal balance, interest rate, repayment period, and any other contractual terms of the seller’s mortgage. Rather than going through the rigorous process of obtaining a home loan from the bank, a buyer can take over an existing mortgage.

There could be a cost-saving advantage if current interest rates are higher than the interest rate on the assumable loan. In a period of rising interest rates, the cost of borrowing also increases. When this happens, borrowers will face high interest rates on any loans approved. Therefore, an assumable mortgage is likely to have a lower interest rate, an attractive feature to buyers. If the assumable mortgage has a locked-in interest rate, it will not be impacted by rising interest rates. A mortgage calculator can be a good resource to budget for the monthly cost of your payment.

An assumable mortgage is attractive to buyers when the existing mortgage rate is lower than current market rates.

What Types of Loans Are Assumable?

Some of the most popular types of mortgages are assumable: Federal Housing Authority (FHA), Veterans Affairs (VA), and the U.S. Department of Agriculture (USDA). Buyers who wish to assume a mortgage from a seller must meet specific requirements and receive approval from the agency sponsoring the mortgage.

FHA loans

FHA loans are assumable when both transacting parties meet the requirements for the assumption. For instance, the property must be used by the seller as their primary residence. Buyers must first verify that the FHA loan is assumable and then apply as they would for an individual FHA loan. The seller’s lender will verify that the buyer meets the qualifications, including being creditworthy. If approved, the mortgage will be assumed by the buyer. However, unless the seller is released from the loan, they are still responsible for it.

VA loans

The Department of Veterans Affairs offers mortgages to qualified military members and spouses of military members. However, to assume a VA loan, the buyer need not be a member of the military to qualify. Although, the lender and the regional VA loan office will need to approve the buyer for the loan assumption, and most often, buyers who assume VA loans are military members.

For loans initiated before March 1, 1988, buyers may freely assume the VA loan. In other words, the buyer does not need the approval of the VA or the lender to assume the mortgage.

USDA loans

USDA loans are offered to buyers of rural properties. They require no down payment and often have low interest rates. To assume a USDA loan, the buyer must meet the standard qualifications, such as meeting credit and income requirements, and receive approval from the USDA to transfer title. The buyer may assume the existing rate of interest and loan terms or new rates and terms. Even if the buyer meets all requirements and received approval, the mortgage cannot be assumed if the seller is delinquent on payments.

Important

Conventional loans backed by Fannie Mae and Freddie Mac are generally not assumable, though exceptions may be allowed for adjustable-rate mortgages.

Advantages and Disadvantages of Assumable Mortgages

The advantages of acquiring an assumable mortgage in a high-interest rate environment are limited to the amount of existing mortgage balance on the loan or the home equity. For example, if a buyer is purchasing a home for $250,000 and the seller’s assumable mortgage only has a balance of $110,000, the buyer will need to make a down payment of $140,000 to cover the difference. Or the buyer will need a separate mortgage to secure the additional funds.

A disadvantage is when the home’s purchase price exceeds the mortgage balance by a significant amount, requiring the buyer to obtain a new mortgage. Depending on the buyer’s credit profile and current rates, the interest rate may be considerably higher than the assumed loan.

Usually, a buyer will take out a second mortgage on the existing mortgage balance if the seller’s home equity is high. The buyer may have to take out the second loan with a different lender from the seller’s lender, which could pose a problem if both lenders do not cooperate with each other. Also, having two loans increases the risk of default, especially when one has a higher interest rate.

If the seller’s home equity is low, however, the assumable mortgage may be an attractive acquisition for the buyer. If the value of the home is $250,000 and the assumable mortgage balance is $210,000, the buyer need only put up $40,000. If the buyer has this amount in cash, they can pay the seller directly without having to secure another credit line.

Pros

  • Buyers may get rates lower than current market rates

  • Buyers may not have to secure new lines of credit

  • Buyers do not have large out-of-pocket costs when the equity is low

Cons

  • Buyers may need substantial down payments when the equity is high

  • Lenders may not cooperate when a second mortgage is needed

  • With two mortgages, the risk of default increases

Assumable Mortgage Transfer Approval

The final decision over whether an assumable mortgage can be transferred is not left to the buyer and seller. The lender of the original mortgage must approve the mortgage assumption before the deal can be signed off on by either party. The homebuyer must apply for the assumable loan and meet the lender’s requirements, such as having sufficient assets and being creditworthy.

A seller is still responsible for any debt payments if the mortgage is assumed by a third party unless the lender approves a release request releasing the seller of all liabilities from the loan.

If approved, the title of the property is transferred to the buyer who makes the required monthly repayments to the bank. If the transfer is not approved by the lender, the seller must find another buyer that is willing to assume his mortgage and has good credit.

A mortgage that has been assumed by a third party does not mean that the seller is relieved of the debt payment. The seller may be held liable for any defaults which, in turn, could affect their credit rating. To avoid this, the seller must release their liability in writing at the time of assumption, and the lender must approve the release request releasing the seller of all liabilities from the loan.

Assumable Mortgages FAQs

What does assumable mean?

Assumable refers to when one party takes over the obligation of another. In terms of an assumable mortgage, the buyer assumes the existing mortgage of the seller. When the mortgage is assumed, the seller is often no longer responsible for the debt.

What does not assumable mean?

Not assumable means that the buyer cannot assume the existing mortgage from the seller. Conventional loans are non-assumable. Some mortgages have non-assumable clauses, preventing buyers from assuming mortgages from the seller.

How does an assumable loan work?

To assume a loan, the buyer must qualify with the lender. If the price of the house exceeds the remaining mortgage, the buyer must remit a down payment that is the difference between the sale price and the mortgage. If the difference is substantial, the buyer may need to secure a second mortgage.

How do I know if my mortgage is assumable?

There are certain types of loans that are assumable. For example, USDA, VA, and FHA loans are assumable. Each agency has specific requirements that both parties must fulfill for the loan to be assumed by the buyer. The USDA requires that the house is in a USDA-approved area, the seller must not be delinquent on payments, and the buyer must meet certain income and credit limits. The buyer should first confirm with the seller and the seller’s lender if the loan is assumable.

Is an assumable mortgage good?

When current interest rates are higher than an existing mortgage’s rates, assuming a loan may be the favorable option. Also, there are not as many costs due at closing. On the other side, if the seller has a considerable amount of equity in the home, the buyer will either have to pay a large down payment or secure a second mortgage for the balance not covered by the existing mortgage.

The Bottom Line

An assumable mortgage may be attractive to buyers when current mortgage rates are high and because closing costs are considerably lower than those associated with traditional mortgages. However, if the owner has a lot of equity in the home, the buyer may need to pay a substantial down payment or secure a new loan for the difference in the sale price and the existing mortgage. Also, not all loans are assumable, and if so, the buyer must still qualify with the agency and lender. If the benefits outweigh the risks, an assumable mortgage might be the best option for homeownership.

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Adjustable-Rate Mortgage (ARM): What It Is and Different Types

Written by admin. Posted in A, Financial Terms Dictionary

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What Is an Adjustable-Rate Mortgage (ARM)?

The term adjustable-rate mortgage (ARM) refers to a home loan with a variable interest rate. With an ARM, the initial interest rate is fixed for a period of time. After that, the interest rate applied on the outstanding balance resets periodically, at yearly or even monthly intervals.

ARMs are also called variable-rate mortgages or floating mortgages. The interest rate for ARMs is reset based on a benchmark or index, plus an additional spread called an ARM margin. The typical index that is used in ARMs has been the London Interbank Offered Rate (LIBOR).

Key Takeaways

  • An adjustable-rate mortgage is a home loan with an interest rate that can fluctuate periodically based on the performance of a specific benchmark.
  • ARMS are also called variable rate or floating mortgages.
  • ARMs generally have caps that limit how much the interest rate and/or payments can rise per year or over the lifetime of the loan.
  • An ARM can be a smart financial choice for homebuyers who are planning to keep the loan for a limited period of time and can afford any potential increases in their interest rate.

Click Play to Learn All About Adjustable-Rate Mortgages

Understanding Adjustable-Rate Mortgages (ARMs)

Mortgages allow homeowners to finance the purchase of a home or other piece of property. When you get a mortgage, you’ll need to repay the borrowed sum over a set number of years as well as pay the lender something extra to compensate them for their troubles and the likelihood that inflation will erode the value of the balance by the time the funds are reimbursed.

In most cases, you can choose the type of mortgage loan that best suits your needs. A fixed-rate mortgage comes with a fixed interest rate for the entirety of the loan. As such, your payments remain the same. An ARM, where the rate fluctuates based on market conditions. This means that you benefit from falling rates and also run the risk if rates increase.

There are two different periods to an ARM. One is the fixed period and the other is the adjusted period. Here’s how the two differ:

  • Fixed Period: The interest rate doesn’t change during this period. It can range anywhere between the first five, seven, or 10 years of the loan. This is commonly known as the intro or teaser rate.
  • Adjusted Period: This is the point at which the rate changes. Changes are made during this period based on the underlying benchmark, which fluctuates based on market conditions.

Another key characteristic of ARMs is whether they are conforming or nonconforming loans. Conforming loans are those that meet the standards of government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac. They are packaged and sold off on the secondary market to investors. Nonconforming loans, on the other hand, aren’t up to the standards of these entities and aren’t sold as investments.

Rates are capped on ARMs. This means that there are limits on the highest possible rate a borrower must pay. Keep in mind, though, that your credit score plays an important role in determining how much you’ll pay. So, the better your score, the lower your rate.

The initial borrowing costs of an ARM are fixed at a lower rate than what you’d be offered on a comparable fixed-rate mortgage. But after that point, the interest rate that affects your monthly payments could move higher or lower, depending on the state of the economy and the general cost of borrowing. 

Types of ARMs

ARMs generally come in three forms: Hybrid, interest-only (IO), and payment option. Here’s a quick breakdown of each.

Hybrid ARM

Hybrid ARMs offer a mix of a fixed- and adjustable-rate period. With this type of loan, the interest rate will be fixed at the beginning and then begin to float at a predetermined time.

This information is typically expressed in two numbers. In most cases, the first number indicates the length of time that the fixed rate is applied to the loan, while the second refers to the duration or adjustment frequency of the variable rate.

For example, a 2/28 ARM features a fixed rate for two years followed by a floating rate for the remaining 28 years. In comparison, a 5/1 ARM has a fixed rate for the first five years, followed by a variable rate that adjusts every year (as indicated by the number one after the slash). Likewise, a 5/5 ARM would start with a fixed rate for five years and then adjust every five years.

You can compare different types of ARMs using a mortgage calculator. 

Interest-Only (I-O) ARM

It’s also possible to secure an interest-only (I-O) ARM, which essentially would mean only paying interest on the mortgage for a specific time frame—typically three to 10 years. Once this period expires, you are then required to pay both interest and the principal on the loan.

These types of plans appeal to those keen to spend less on their mortgage in the first few years so that they can free up funds for something else, such as purchasing furniture for their new home. Of course, this advantage comes at a cost: The longer the I-O period, the higher your payments will be when it ends.

Payment-Option ARM

A payment-option ARM is, as the name implies, an ARM with several payment options. These options typically include payments covering principal and interest, paying down just the interest, or paying a minimum amount that does not even cover the interest.

Opting to pay the minimum amount or just the interest might sound appealing. However, it’s worth remembering that you will have to pay the lender back everything by the date specified in the contract and that interest charges are higher when the principal isn’t getting paid off. If you persist with paying off little, then you’ll find your debt keeps growing—perhaps to unmanageable levels.

Advantages and Disadvantages of ARMs

Adjustable-rate mortgages come with many benefits and drawbacks. We’ve listed some of the most common ones below.

Advantages

The most obvious advantage is that a low rate, especially the intro or teaser rate, will save you money. Not only will your monthly payment be lower than most traditional fixed-rate mortgages, you may also be able to put more down toward your principal balance. Just ensure your lender doesn’t charge you a prepayment fee if you do.

ARMs are great for people who want to finance a short-term purchase, such as a starter home. Or you may want to borrow using an ARM to finance the purchase of a home that you intend to flip. This allows you to pay lower monthly payments until you decide to sell again.

More money in your pocket with an ARM also means you have more in your pocket to put toward savings or other goals, such as a vacation or a new car.

Unlike fixed-rate borrowers, you won’t have to make a trip to the bank or your lender to refinance when interest rates drop. That’s because you’re probably already getting the best deal available.

Disadvantages

One of the major cons of ARMs is that the interest rate will change. This means that if market conditions lead to a rate hike, you’ll end up spending more on your monthly mortgage payment. And that can put a dent in your monthly budget.

ARMs may offer you flexibility but they don’t provide you with any predictability as fixed-rate loans do. Borrowers with fixed-rate loans know what their payments will be throughout the life of the loan because the interest rate never changes. But because the rate changes with ARMs, you’ll have to keep juggling your budget with every rate change.

These mortgages can often be very complicated to understand, even for the most seasoned borrower. There are various features that come with these loans that you should be aware of before you sign your mortgage contracts, such as caps, indexes, and margins.

How the Variable Rate on ARMs Is Determined

At the end of the initial fixed-rate period, ARM interest rates will become variable (adjustable) and will fluctuate based on some reference interest rate (the ARM index) plus a set amount of interest above that index rate (the ARM margin). The ARM index is often a benchmark rate such as the prime rate, the LIBOR, the Secured Overnight Financing Rate (SOFR), or the rate on short-term U.S. Treasuries.

Although the index rate can change, the margin stays the same. For example, if the index is 5% and the margin is 2%, the interest rate on the mortgage adjusts to 7%. However, if the index is at only 2% the next time that the interest rate adjusts, the rate falls to 4% based on the loan’s 2% margin.

The interest rate on ARMs is determined by a fluctuating benchmark rate that usually reflects the general state of the economy and an additional fixed margin charged by the lender.

Adjustable-Rate Mortgage vs. Fixed Interest Mortgage

Unlike ARMs, traditional or fixed-rate mortgages carry the same interest rate for the life of the loan, which might be 10, 20, 30, or more years. They generally have higher interest rates at the outset than ARMs, which can make ARMs more attractive and affordable, at least in the short term. However, fixed-rate loans provide the assurance that the borrower’s rate will never shoot up to a point where loan payments may become unmanageable.

With a fixed-rate mortgage, monthly payments remain the same, although the amounts that go to pay interest or principal will change over time, according to the loan’s amortization schedule.

If interest rates in general fall, then homeowners with fixed-rate mortgages can refinance, paying off their old loan with one at a new, lower rate.

Lenders are required to put in writing all terms and conditions relating to the ARM in which you’re interested. That includes information about the index and margin, how your rate will be calculated and how often it can be changed, whether there are any caps in place, the maximum amount that you may have to pay, and other important considerations, such as negative amortization.

Is an ARM Right for You?

An ARM can be a smart financial choice if you are planning to keep the loan for a limited period of time and will be able to handle any rate increases in the meantime. Put simply, an adjustable-rate mortgage is well suited for the following types of borrowers:

  • People who intend to hold the loan for a short period of time
  • Individuals who expect to see a positive change in their income
  • Anyone who can and will pay off the mortgage within a short time frame

In many cases, ARMs come with rate caps that limit how much the rate can rise at any given time or in total. Periodic rate caps limit how much the interest rate can change from one year to the next, while lifetime rate caps set limits on how much the interest rate can increase over the life of the loan.

Notably, some ARMs have payment caps that limit how much the monthly mortgage payment can increase, in dollar terms. That can lead to a problem called negative amortization if your monthly payments aren’t sufficient to cover the interest rate that your lender is changing. With negative amortization, the amount that you owe can continue to increase, even as you make the required monthly payments.

Why Is an Adjustable-Rate Mortgage a Bad Idea?

Adjustable-rate mortgages aren’t for everyone. Yes, their favorable introductory rates are appealing, and an ARM could help you to get a larger loan for a home. However, it’s hard to budget when payments can fluctuate wildly, and you could end up in big financial trouble if interest rates spike, particularly if there are no caps in place.

How Are ARMs Calculated?

Once the initial fixed-rate period ends, borrowing costs will fluctuate based on a reference interest rate, such as the prime rate, the London Interbank Offered Rate (LIBOR), the Secured Overnight Financing Rate (SOFR), or the rate on short-term U.S. Treasuries. On top of that, the lender will also add its own fixed amount of interest to pay, which is known as the ARM margin.

When Were ARMs First Offered to Homebuyers?

ARMs have been around for several decades, with the option to take out a long-term house loan with fluctuating interest rates first becoming available to Americans in the early 1980s.

Previous attempts to introduce such loans in the 1970s were thwarted by Congress, due to fears that they would leave borrowers with unmanageable mortgage payments. However, the deterioration of the thrift industry later that decade prompted authorities to reconsider their initial resistance and become more flexible.

The Bottom Line

Borrowers have many options available to them when they want to finance the purchase of their home or another type of property. You can choose between a fixed-rate or adjustable-rate mortgage. While the former provides you with some predictability, ARMs offer lower interest rates for a certain period of time before they begin to fluctuate with market conditions. There are different types of ARMs to choose from and they have pros and cons. But keep in mind that these kinds of loans are better suited for certain kinds of borrowers, including those who intend to hold onto a property for the short term or if they intend to pay off the loan before the adjusted period begins. If you’re unsure, talk to a financial expert about your options.

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