Interest
Rates
Interest rates are the name of the game when it comes to shopping for a home loan. But it is not as simple as finding a mortgage company and getting a quote. There are hundreds of programs and many options to these programs that will affect your decision. Be sure to check the APR of your quoted rate, which will calculate included fees. APR
Annual Percentage Rate
In comparing any
type of loan, whether it be a fixed rate loan to a fixed rate loan,
adjustable rate loan to adjustable rate loan or fixed rate loan to
adjustable rate loan, there is one way that can be used to compare apples
to apples and even apples to oranges. APRs are designed
to do just that. APRs are a way to calculate the annual cost of loans,
taking into consideration loan origination fees (points) and the other
costs associated with securing a loan. The additional costs include
appraisal and credit report fees as well as processing and document fees. One confusing
aspect of APRs is that the APR on 15 year loans will carry a higher
relative rate due to the fact that the points are amortized over the 15
year term rather than the 30 year term. (See chart below) When a
Regulation Z (Reg Z, the lender's disclosure of cost for the loan) is
prepared for a buyer/borrower the prepaid interest is also included in the
APR calculation. For our illustrations we will use only the points,
appraisal, credit report, processing and document fees. As a means of
protecting consumers from lenders who did not disclose the fees associated
with a particularly low start rate on an adjustable rate loan or below
market rate on a fixed rate loan, APRs give consumers a way to check the
true cost of a loan. Regulation Z
One common
situation that occurs when a borrower receives a Reg Z, and a copy of
their note, is the column that indicates the amount financed is less than
the loan amount the borrower is actually financing. It is here that many
borrowers leap before they look and call to find out why they are only
receiving a $146,925 loan when they applied for a $150,000 loan. It is
here that APRs enter the picture. Let's look at how
APRs are calculated. For our illustration we will assume a 8.50% fixed
rate interest. For a 30 year loan the monthly payments for a $150,000 loan
are $1,153.37. In order to
calculate the APR for this loan we subtract $2,250.00 (1.50 points),
$275.00 appraisal fee, $50.00 credit report fee, $500.00 processing,
document and other fees. ($150,000 - $3,0750 = $146,925). The $146,925 is
then used as the present value/loan amount to determine the true cost of
this loan. By solving for the new interest rate for a $146,925 loan with
the same payment of $1,153.37, the APR is calculated as 8.73%. How does this
compare to a 30 year fixed rate loan with a 8.00% interest rate and 3.50
points? The monthly payments for this loan is $1,100.65. In order to
calculate the APR for this loan we subtract $5,255.00 (3.50 points),
$275.00 appraisal fee, $50.00 credit report fee, $500.00 processing,
document and other fees. ($150,000 - $6,075 = $143,925). The $143,925 is
then used as the present value/loan amount to determine the true cost of
this loan. By solving for the new interest rate for a $143,925 loan with
the payment of $1,100.65 the APR is calculated as 8.44%. Loan Decision
using APRs In choosing which
loan is best for your needs, it is important to look at other factors in
addition to the APR. If you don't plan on keeping the property or the loan
for the full term, the calculation of actual costs needs to be adjusted,
generally this will increase the APR calculation. Below is an
example of how the APR differential increases based on holding the loan
for a shorter period of time. ASSUMPTION -
$250,000 LOAN and 30 YEAR TERM
Calculating
APRs on adjustable rate loans (ARMs) is a much different set of
calculations. For ARMs you need to take in to consideration not only the
starting interest rate, but any adjustments that will occur until you
reach the fully indexed rate. In
calculating APRs on adjustable rate mortgages (ARMs) you need to take in
to consideration not only the starting interest rate, but any adjustments
that will occur until you reach the fully indexed rate. The fully indexed
rate is determined by adding the index to the margin. Assuming
an ARM with a start rate of 6.25% at 1.50 points with a margin of 2.75
over the 1-Year Treasury Security (6.39 index) with annual adjustments of
2%, the APR calculations for a $150,000 loan would be as follows. The
first years payments would be $923.58. Factoring for principal reduction
the following payment schedule would occur. Second year 8.25% interest,
payment $1201.23. At this point the loan will reach the fully indexed rate
of 9.25% interest, (Index value 6.39 + margin value 2.75 = 9.14 , rounded
up to the nearest 1/8th percent or 9.25%) payment $1327.13. For
determining the APR this payment and interest rate is assumed for the
remainder of the 30 year term. There
are a few ways in which you can solve for the APR in this case, first you
could run a IRR (internal rate of return) calculation, time-consuming and
complicated at best. You could design a spread sheet to do so, or you can
take the sum of the payments and determine what the average payment would
be for the 30 year term. In
this scenario, the sum of the payments for the 360 months in question is
$444,089.53, or an average monthly payment of $1,233.58. This is used as
the payment for calculating the APR. In
order to calculate the APR for this loan subtract $2,250.00 (1.50 points),
$275.00 appraisal fee, $50.00 credit report fee, $500.00 processing,
document and other fees. ($150,000 - $3,075 = $146,925). The $146,925 is
then used as the present value/loan amount to determine the true cost of
this mortgage. By solving for the interest rate for a $146,925 loan with
the same payment of $1,233.58 the APR is calculated as 9.473%. Monthly
Adjustables Calculating
APRs for monthly adjustable rate mortgages is just a bit different. For a
monthly ARM (one with potential negative amortization) you need to take
into consideration only the starting interest rate, and one adjustment to
the fully indexed rate. Assuming
an ARM with a start rate of 4.50% at 1.50 points with a margin of 2.50
over the 11th District Cost of Funds (4.747 index) reaching it's fully
indexed rate on the fourth month the APR calculation for the same $150,000
would be as follows. The
first 3 months payments would be $760.03 At this point the loan is fully
indexed at 7.247%, factoring for principle reduction the payment for the
remainder of the term is $1,021.31. For determining the APR this payment
is used for the remainder of the 30 year term. In
this scenario, the sum of the payments for the 360 months in question is
$366,887.34, or an average monthly payment of $1,019.13. This payment is
used for calculating the APR. In
order to calculate the APR for this loan subtract $2,250.00 (1.50 points),
$275.00 appraisal fee, $50.00 credit report fee, $500.00 processing,
document and other fees. ($150,000 - $3,075 = $146,925). The $146,925 is
then used as the present value/loan amount to determine the true cost of
this mortgage. By solving for the interest rate for a $146,925 loan with
the same payment of $1,019.13 the APR is calculated as 7.41%. Based on just the APR comparison the second loan appears to cost less. Choosing which ARM loan is best for your needs with just APRs can be a mistake. With ARMs you also want to look at the life time cap, the history of the index and also the current trend of the index values you are comparing. ARMS
Adjustable Rate Mortgages
Most adjustable
rate loans (ARMs) have a low introductory rate or start rate, some times
as much as 5.0% below the current market rate of a fixed loan. This start
rate is usually good from 1 month to as long as 10 years. As a rule the
lower the start rate the shorter the time before the loan makes its first
adjustment. INDEX MARGIN INTERIM CAPS PAYMENT CAPS LIFETIME CAPS Buydowns
2-1 Annual
Buydowns The most common
buydown is the 2-1 buydown. In the past, for a buyer to secure a 2-1
buydown they would pay 3 points above current market points in order to
pay a below market interest rate during the first two years of the loan.
At the end of the two years they would then pay the old market rate for
the remaining term. As an example, if
the current market rate for a conforming fixed rate loan is 8.5% at a cost
of 1.5 points, the buydown gives the borrower a first year rate of 6.50%,
a second year rate of 7.50% and a third through 30th year rate of 8.50%
and the cost would be 4.5 points. Buydown were usually paid for by a
transferring company because of the high points associated with them. In today's market
lenders have designed variations of the old buydowns. Rather than charge
higher points to the buyer in the beginning they increase the note rate to
cover their yields in the later years. As an example, if
the current rate for a conforming fixed rate loan is 8.50% at a cost of
1.5 points, the buydown would give the buyer a first year rate of 7.25%, a
second year rate of 8.25% and a third through 30th year rate of 9.25% , or
a three-quarter point higher note rate than the current market and the
cost would remain at 1.5 points. 3-2-1 and
Flex-Fixed Buydowns Another common
buydown is the 3-2-1 buydown which works much in the same ways as the 2-1
Buydown, with the exception of the starting interest rate being 3% below
the note rate. Another variation is the flex-fixed buydown programs that
increase at six month interval rather than annual intervals. As an example, for a flex-fixed Jumbo buydown at a cost of 1.5 points, the first six months rate would be 7.50%, the second six months the rate would be 8.00%, the next six months rate would be 8.50%, the next six months rate would be 9.00%, the next six months the rate would be 9.50% and at the 37th month the rate would reach the note rate of 9.875% and would remain there for the remainder of the term. A comparable Jumbo 30 year fixed at 1.5 points would be 8.875%. COFI
Cost of Funds Index
The 11th District
Cost of Funds is more prevalent in the West and the 1-Year Treasury
Security is more prevalent in the East. Buyers prefer the slowly moving
11th District Cost of Funds and investors prefer the 1-Year Treasury
Security. The monthly
weighted average Eleventh District has been published by the Federal Home
Loan Bank of San Francisco since August 1981. Currently more than one half
of the savings institutions loans made in California are tied to the 11th
District Cost of Funds (COF) index. The federal Home
Loan Banks 11th District is comprised of saving institutions in Arizona,
California and Nevada. Few people who
use and follow the 11th District Cost of Funds understand exactly how it
is calculated, what it represents, how it moves and what factors affect
it. The predecessor
to the 11th District Cost of Funds index was the District semiannual
weighted average cost of funds published for a six month period ending in
June and December. The San Francisco Bank was the first Federal Home Loan
Bank to publish a monthly cost of funds index. The funds used as
a basis for the calculation of the 11th District Cost of Funds index are
the liabilities at the District savings institutions: money on deposit at
he institutions, money borrowed from a Federal Home Loan Bank (known as
advances) and all other money borrowed. The interest paid on these types
of funds is the cost of these funds. The ratio of the
dollar amount paid in interest during the month to the average dollar
amount of the funds for that month constitutes the weighted average cost
of funds ratio for that month. The average cost of funds is said to be weighted because the three kinds of funds and their costs are added together before a ratio is computed rather than calculating averages individually for the three sources and using a simple average of the three ratios. This gives the greatest weight to the interest paid on deposits, and explains the delayed reaction of the index to rising fixed-rate mortgages. GPM
Graduated Payment Mortgage
The GPM is
another alternative to the conventional adjustable rate mortgage, and is
making a comeback as borrowers and lenders seek alternatives to assist in
qualify for home financing Unlike an ARM,
GPMs have a fixed note rate and payment schedule. With a GPM the payments
are usually fixed for one year at a time. Each year for five years the
payments graduate at 7.5% - 12.5% of the previous years payment. GPMs are
available in 30 year and 15 year amortization, and for both conforming and
jumbo loans. With the graduated payments and a fixed note rate, GPMs have
scheduled negative amortization of approximately 10% - 12% of the loan
amount depending on the note rate. The higher the note rate the larger
degree of negative amortization. This compares to the possible negative
amortization of an monthly adjusting ARM of 10% of the loan amount. Both
loans give the consumer the ability to pay the additional principal and
avoid the negative amortization. In contrast, the GPM has a fixed payment
schedule so the additional principal payments reduce the term of the loan.
The ARMs additional payments avoid the negative amortization and the
payments decrease while the term of the loan remains constant. Scheduled
Negative Amortization The scheduled
negative amortization on a GPM differs depending on the amortization
schedule, the note rate and the payment increases of the loan. GPM loans
with 7.5% annual payment increases offer the lowest qualifying rate but
the largest amount of negative amortization. On a loan of
$150,000, with a 30 year amortization and a note rate of 10.50% with 12.5%
annual payment increases, the negative amortization continues for 60
months. The qualifying rate is 5.75% and the negative amortization is
11.34% (approximately $17,010). Help in
Qualifying The note rate of
a GPM is traditionally .5% to .75% higher than the note rate of a straight
fixed rate mortgage. The higher note rate and scheduled negative
amortization of the GPM makes the cost of the mortgage more expensive to
the borrower in the long run. In addition, the borrowers monthly payment
can increase by as much as 50% by the final payment adjustment. The lower qualifying rate of the GPM can help borrowers maximize their purchasing power, and can be useful in a market with rapid appreciation. In markets where appreciation is moderate, and a borrower needs to move during the scheduled negative amortization period they could create an unpleasant situation. LIBOR
(London InterBank Offered Rate
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