Adjustable-Rate Mortgages (ARMs)
Discounts and Payment Shock
Discounts
Some lenders offer initial adjustable-rate mortgage (ARM) rates
that are lower than their "standard" ARM rates (lower
than the sum of the index and the margin). Such rates, called
discounted rates, are often combined with large initial loan fees
("points") and with much higher rates after the discount
expires.
Very large discounts are often arranged by the seller. The seller
pays an amount to the lender so that the lender can give you a
lower rate and lower payments early in the mortgage term. This
arrangement is called a "seller buydown." The seller
may increase the sales price of the home to cover the cost of
the buydown.
A lender may use a low initial rate to decide whether to approve
your loan, based on your ability to afford it. You should be careful
and consider whether you will be able to afford payments in later
years when the discount expires and the rate is adjusted.
Here is how a discount might work. Let's assume that the lender's
"standard" one-year ARM rate (index rate plus margin)
is currently 10%, but your lender is offering an 8% rate for the
first year. With the 8% rate, your first-year monthly payment
would be $476.95. After the first 12 months, however, you run
the risk of payment shock.
Payment Shock
Payment shock may occur if your mortgage payment rises very sharply
at the first adjustment. Don't forget that with a discounted ARM,
any savings during the discount period may be made up during the
life of the mortgage or may be included in the price of the house.
Let us see what would happen in the second year if the rate on
your discounted 8% ARM were to rise to the 10% "standard"
rate.
|
ARM
Interest Rate |
Monthly
Payment |
|
1st year (w/discount) @ 8% |
$ 476.95 |
|
2nd year @ 10% |
$ 568.82 |
As the example shows, even if the index rate were to stay the
same, your monthly payment would go up from $476.95 to $568.82
in the second year.
Suppose that the index rate increases 2% in one year and the ARM rate rises
to 12%.
|
ARM
Interest Rate |
Monthly
Payment |
|
1st year (w/discount) @ 8% |
$ 476.95 |
|
2nd year @ 12% |
$ 665.43 |
That is an increase of almost $200 in your monthly payment. You
can see what might happen if you choose an ARM because of a low
initial rate. You can protect yourself from large increases by looking
for a mortgage with features, described next, that may reduce this
risk.
The information provided in this website is
not legal advice and should not be interpreted as legal advice.
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information in summary form. This information may not be comprehensive,
is subject to change, and may not apply to all individual circumstances.
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