As you read reports of borrowers who were surprised when payments on their adjustable-rate mortgages shot up from introductory teaser rates, or who were thwarted in their attempt to refinance because they discovered that their current loan has a stiff prepayment penalty, you might start to wonder if any such surprises lurk in your own mortgage. Dust off the old loan documents and look for some of these key terms, in case you have lingering doubts. If you are applying for a new loan, discuss these points with your loan officer.
Fixed-rate or ARM?
If it says your rate is fixed, check to see how long it will remain fixed. Thirty years? Five years? Six months? Unless it says 30 years (or more), you have some type of adjustable-rate mortgage, or ARM.
If it is an ARM, look for three things: the index, the margin and the adjustment or reset period. The index will be something widely published, such as the rate on one-year Treasury securities or a Federal Reserve cost of funds index called the COFI. Check the current rate for the various indixeson Bankrate’s Rate Watch page. The lender will add a markup, called the margin, which could be 2 or 3 percentage points or it could be twice that or even more for a borrower with poor credit. The index plus margin determines your new interest rate. Look for caps on how much that interest rate can change at each adjustment period and over the life of the loan, and make sure the caps limit the interest rate charged, and not just the payment that can be collected. The adjustment period will tell you how frequently your interest rate will change.
Some ARMs allow convertibility to a fixed-rate loan at some point. This is a valuable feature, and borrowers typically have to pay extra for it. Look for this word in your loan documents, or ask your loan officer if you’re not sure whether your loan has this feature.
Fully-amortizing or negative amortization?
Typical 30-year fixed-rate mortgages are fully amortizing, which means the payments will progressively pay back the full amount of money borrowed, plus all interest due, within the loan’s 30-year lifespan. Some ARMs allow negative amortization, which means at some points the required monthly payment may not be enough to pay back the full amount owed according to that loan’s lifespan. Check all loan documents for the words “negative amortization.” If that is a possibility, it will be stated somewhere in the contract. If negative amortization is allowed, then you need to see how high your payment could jump when your outstanding debt triggers a recast of the loan — the drawing up of a new payment schedule designed to pay off the loan on time. Required payments can be dramatically higher after the loan is recast!
Some loans, especially those offered to high-risk “subprime” borrowers, may charge prepayment penalties of several thousand dollars if the borrower pays back the loan during the first three to five years or so. Some trigger the penalty only if the borrower tries to refinance into a different mortgage, but others trigger the penalty even if the borrower sells the home and pays off the mortgage. Review your contract for the presence of prepayment penalties.
A relatively small number of mortgages call for a large lump-sum payment at the end, called a balloon payment. Borrowers need to be prepared to refinance well in advance of the date when such a balloon comes due.
You can get more help understanding these issues from local housing counseling agencies. For a referral, contact the U.S. Department of Housing and Urban Development, toll-free, at (800) 569-4287, or www.hud.gov.
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