Your Adjustable Rate Mortgage: Blessing or Bomb?

As a loan officer I used to plot several graphs for my clients considering adjustable rate mortgages (ARMs). I’d routinely show them the best case, worst case, and most likely scenarios, and let them decide if they wanted the savings of the ARM or the safety of the fixed loan. If you’re trying to decide whether to keep your ARM today or refinance it, you can perform the same kind of analysis yourself.

First, Look at the Terms of Your ARM

Your paperwork should contain an ARM rider that should give you these pieces of information: Your start rate, your index, your margin, and any rate or adjustment caps and floors. For example, you might have a 3/1 ARM with a start rate of 4%, based on the 1-year LIBOR index, with a margin of 2%, annual adjustments capped at 2%, a lifetime cap of 10%, and a floor of 3%. Your 4% mortgage is set to adjust in a month; what will it do?

Check Your Index

You can find index data on most financial Web sites. The 1-year LIBOR index as of February 2010 is .85158. If your mortgage were adjusting today, you’d add your margin of 2% and get a rate of 2.852%!

Check Your Caps and Floors

But wait, there’s more. Your loan has a floor of 3%, which means that your rate can’t drop below 3% no matter what the LIBOR does. So you’d be at 3%, which isn’t bad. And that 3% is your best case scenario. So what’s your worst-case scenario? Check your caps–your rate can’t increase more than 2% per year. So, if you adjusted to a 3% rate next month, in a year the highest your rate could be go would be to 5%, then the following year to 7%, then 9%, then it would top out at 10% and stay there. So much for worst case.

What’s More Likely?

Best and worst case scenarios are extremes and unlikely to resemble the progress of your actual loan, especially over the long term. But you can predict a more likely and reasonable course for your mortgage. Here’s how: a search of “historical average 1 year LIBOR” online gets me the data I want. I dump it into a spreadsheet and I discover that the average of the 1-year LIBOR since its inception in 1990 is 4.623%. So we can add that to your margin of 2% for a total of 6.623%.

Yes, I could be a statistical stinker and make you calculate the expected value, but an average is a fairly good substitute and no one ever committed suicide trying to calculate an average. It’s a fairly safe bet, then, that your loan will adjust to 3% next month, 5% the following year, and then it may fluctuate around that 6.623% rate over the years–there’s no guaranty, but the longer you have your loan, the more likely it is that your rate will behave itself.

So, Should You Fix Your Interest Rate or Not?

That depends. Fixed rates today are about 5% if you have good credit–less than the average LIBOR ARM rate of 6.623%. You’d probably save money in the long run by refinancing. But what if you’re not in it for the long haul? If this house is a starter, or you have job transfers every five years or so, leaving your ARM alone is probably a safe bet. You know your rate won’t exceed 7% for at least three years.

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Can I Refinance a Second Home?

Refinancing a second home with Fannie or Freddie Mac doesn’t cost any more than refinancing a comparable primary home. There are no risk-based pricing adjustments for second homes. While financing an investment property at 80% of its value can add 3.75 points to your fees, that’s not the case with a second home that meets eligibility requirements.

You Need Equity to Refinance a Second Home

You might have been able to purchase your second home with only 10% down, but you won’t be able to refinance it with only 10% home equity. That’s because for loans of more than 80% of your vacation home’s value, you’ll need mortgage insurance, and that can be hard to get.

You’ll Need Income to Refinance Your Second Home

Lenders prefer that your first mortgage (principal, interest, taxes, insurance, and homeowners’ dues) doesn’t exceed 31% of your gross monthly income. But your second home had better cost a lot less than that. Your second home payment is counted in with all of your other debts, like car loans and credit cards. Those payments, plus the loan on your primary residence, make up your total debt-to-income ratio. The lender on your primary residence isn’t so worried about those, because if your income decreases, you’ll likely use the first 31% of your income to keep up with your mortgage even if you have to miss payments to the other guys.

However, the lender on your second home IS one of those other guys. So while a first mortgage lender is often okay with you having a debt-to-income ratio of 45%, the second mortgage lender won’t want to see it over 40%, and that’s if you’re otherwise very well qualified.

Second Home vs Investor Property

Financing a second home is cheaper and easier than financing a rental. But what if you have been renting out your vacation home? Can you still refinance it as a second home? That depends. If your rental activity shows up on your tax returns and your lender requests them to verify your income, no way. Ditto if the appraiser the lender sends is met by a rental agent. Here are Fannie Mae’s official second home requirements:

• Must be located a reasonable distance away from the borrower’s principal residence. You can’t vacation in your home town.
• Must be occupied by the borrower for some portion of the year–ski cabin, beach house, whatever.
• Must be a one-unit dwelling (no duplexes, etc.).
• Must be suitable for year-round occupancy–tree houses and igloos don’t cut it.
• Must not be rental property, a timeshare arrangement, or controlled by anyone but you.

So, if you qualify, you should be able to get the best mortgage rates available and save money–and that means more barbecues, more cold drinks, more marshmallows around the fire, more hikes, more sailing, more of whatever you love most at your vacation hide-away.

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Choosing and Using a Debt Management Program

A debt management service acts as a liaison between you and your creditors. They negotiate a single for you, collect a single monthly payment, and distribute it to your creditors. The service charges a commission, usually a percentage of your monthly payment, and may also get rebates from your creditors.

How Debt Management Affects Your Credit

If your debt management service negotiates reduced interest rates or balance reductions on your behalf, it may show up on your credit record because you won’t be paying as agreed. However, the effect on your credit is much less damaging than late and missed payments.

If you made a timely monthly payment to your debt management service, but it doesn’t make your payments to your creditors on time, find out why. If the service neglects to pay your debts on time, your credit will suffer. Also, if the service charges you more than expected and applies your monthly payment to fees instead of paying your creditors, discontinue the service and contact your creditors directly.

Debt Consolidation Is an Alternative

It is not unusual for a debt management service to charge a commission of 10 percent on your monthly payment. The firm may also obtain a rebate from your lenders on the amount of each monthly payment they make on your behalf, which actually creates a conflict of interest since they are supposed to be working for you but are getting paid by your creditors.

There are unethical debt management services that encourage people to sign up for services which are not in their best interest, and non-profit status is no guarantee that a service is ethical. Look for services accredited by the Association of Independent Consumer Credit Counseling Agencies or the National Foundation for Credit Counseling.

Instead of debt management plans, you may want to consider a debt consolidation loan. This gets you a single monthly payment, but there are no service charges and your debts are discharged immediately. Then all you have to do is make the monthly payment to the debt consolidation lender. Another alternative is to try to negotiate lower interest rates and payments with your creditors on your own.

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My Lender Won’t Give Me a Good Faith Estimate!

The new GFE is expected to save borrowers an average of $700 per mortgage transaction, according to HUD. It makes shopping for a mortgage refinance easier and more transparent, putting the terms of your home loan upfront where you can easily see them, and including a worksheet to compare different home loans. But many lenders don’t like to give out GFEs to people until they are required to by law, and the law doesn’t apply to casual shoppers looking for mortgage rate quotes. So how can you get a GFE that commits the lender to the rate and fees it quotes you?

GFE = Increased Risk to Lender

Every time it issues a GFE, the lender assumes some extra risk. That’s because even fees charged by third party providers like title companies must be guaranteed within certain tolerances. And a mistake by an employee can cost a lender the entire profit on a mortgage transaction. For example, if someone prepares a GFE and mistakenly inputs title charges of $800 and the actual charges end up being $1,100, you have to pay only $880 (the estimated charges plus an allowed 10% tolerance), and your lender has to pay the remaining $220.

Easier for You = Harder for Some Lenders

While many lenders have no problem at all with issuing GFEs, and most welcome the transparency which makes it harder for the bad guys to compete unfairly with bait-and-switch tactics, some prefer not to disclose interest rates and fees upfront. The longer you are involved with a lender, the less likely you are to shop around for your loan. An article in Mortgage Professional Magazine counsels loan agents to avoid issuing a GFE until it’s required by law and also advises them not to guarantee an interest rate more than one day.

So, How Do You Get a GFE?

Pass up any lender that doesn’t feel it’s interest rates will stand up to comparison. If you provide the following information, it triggers the requirement for a GFE within three days:

• Your full name
• Your monthly income
• Your Social Security number
• The property address
• The loan amount
• The property value or sales price

Once the lender has all of this information, you get to have a GFE and all the guarantees that come with it. Other factors that can change the price of your mortgage are the property use and property type. Verify how long the mortgage rate is guaranteed–mortgage rates change with financial markets all day long so don’t expect a rate to be in force for long unless you lock it in.

A new GFE can be triggered by changes in income, property value / sales price, loan program, locking your rate, or your lock expiration. The final GFE is the only one that must essentially match your settlement statement. To be thorough, shop now, and then shop again when you prepare to lock your refinance interest rate.

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Can Debt Management Improve Your Financial Health?

Debt management (not to be confused with debt settlement) involves restructuring your debts to lower your payments and interest rates. The idea is to help you pay off your consumer debt faster. Debt management typically involves some counselling to help you learn about budgeting, making your payments on time, and managing your bills. Debt management may also involve consolidating your debts with a home equity loan or a personal loan. Lower payments on your consumer debt can make it easier to afford a home loan and may help you save up a down payment.

Debt Management Has Side Effects

However, debt management may also have some consequences you are unprepared for. If your credit report shows that you are in a credit counseling or debt management plan, for example, FHA lenders treat you the same way they would if you had filed for a Chapter 13 bankruptcy. You may be able to get a mortgage, but you’ll have to have been paying on your plan for at least twelve months. The effect on your credit score usually depends on who your creditors are and their policy for reporting your payments.

Citibank, for example, merely adds a note to your payment history that you are enrolled in a credit counseling program. And that notation has no influence on your FICO score. But First USA reports its cardholders as delinquent until they have made three consecutive on-time payments through their debt management plans. Those three late payments can torpedo a score by a hundred points!

So Should You Try Debt Management?

Despite the claims of some TV advertisers, enrolling in credit counseling or debt management is not for those who just want more favorable terms from their creditors. If you can make your payments, but just want a lower interest rate, don’t put your credit score at risk; just call your creditors yourself and ask for a lower interest rate. If they don’t budge, you can always move your account.

Conversely, if no plan could get you out of debt in five years or less, bankruptcy may be a better option. Most credit counseling or debt management plans are designed to retire your debts in two to four years if you stick to them. If your debt will stretch out for years and years, it’s probably time to talk to a lawyer. A bankruptcy trustee could put you in a Chapter 13 program that could get you debt free in three to five years.

Debt management is a viable alternative if you can’t make anything more than your minimum payments or your debt payments exceed your income. But skip the “as-seen-on-TV” outfits. Look for an accredited consumer credit counseling service that provides genuine help.

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Refinance or Reamortize Your Mortgage?

When you’re just starting out, the best mortgage is often one that lets you make lower payments in the early years and bump them up them as your career takes off and your earnings increase. And there are many interest-only and ARM products available to meet this need. But what about as you near retirement? Is there a product for you, too?

Not really. The best mortgage for somewhat at the end of a career would let you pay more at the beginning, when you are in your peak earning years, and taper off to a lower payment when the pension kicks in. And there’s no such animal. Unless you create it yourself.

Prepaying Your Mortgage Now Gives You a Cushion Later

Once your retirement is fully funded, concentrate on prepaying your mortgage as much as you can afford. If you can refinance to a 15-year loan, by all means do so. If not, make whatever principal reduction payments you can. Say for example that you refinance today to a 30-year loan at 5.25%, and you plan on retiring in ten years. Your balance is $300,000. Using a mortgage amortization calculator, you can see that your payment is $1,657 per month and in ten years your balance would be $245,845. But you’re earning enough to pay $2,500 a month without causing yourself undue pain. So you add $843 to your payment. In ten years, your balance is only $113,176.

Now, here’s the good part. You don’t want to pay $2,500 when you’re retired. You don’t want to pay $1,657 either. By having your lender re-amortize your loan (many will do it for a $250 fee), you get a payment obligation of only $763 per month. This is because your prepaid balance is stretched out over the remaining 20-year term of your home loan, allowing you to pay more when you have it and less when you don’t.

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Advantages of Refinancing Online?

With the advent of the Internet, people are selling everything online, and there is no exception with a mortgage refinancing. Online there are a plethora of companies out there vying for your business. If you look around and check a company out before sharing your personal information, online mortgage refinancing might be the right fit for you.

Many people are concerned about transmitting personal data over the web. Because of all of the identity theft going on, this is a valid concern. There are some practical ways that you can protect yourself. First of all, when you are considering a company, check them out on the Better Business Bureau's website. This will help you see how they treat their customers. Another thing that is an absolute must is to be sure that they have a secure website. The way you can know this is if you go to their site and the http turns into an https. The s means that it is secure. A secure website is one in which security measures have been implemented to prevent hackers from stealing your information. This may not appear until you are accessing a sensitive area of their site.

One of the advantages of refinancing your mortgage online is speed. There is little need to coordinate schedules or make an appointment. Everything except the closing is done via email or telephone. This is ideal for the busy working person who has little time to spend in a traditional mortgage office.

Another plus is the competitive rates available with online mortgage companies. Because there are so many places competing for your business, you could wind up with a very low interest rate. Many sites will give you quotes from several different firms and you can choose which one you like best. If one company is lower, but you would prefer to do business with another, ask if they will match the lower rate. Many online mortgage companies will do this in order to earn your business.

Getting a mortgage quote online is easy and quick. You can do it from the comfort of your own home, and avoid uncomfortable face to face meetings with pushy mortgage brokers. It is simple to find interest rates online and, many times, they are lower than the rates traditional mortgage companies offer. Just be careful of the quotes that are several percentage points lower than the majority of the ones you have received. If it sounds too good to be true, it usually is. Be sure you are dealing with a reputable company or your great deal may turn into great big headache.

Online mortgage refinancing is a wonderful choice for many people. More and more consumers are turning to the internet to take care of their finances. As a result, many great deals can be found that can better your situation tremendously. As long as you are cautious, refinancing your mortgage online can be a simple, painless and rewarding experience.

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