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Consumer Cautions
Some lenders offer initial ARMS rates that are lower than their “standard” ARM rates (that is, 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.
Glossary of Terms
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Payment Shock! ARMS Initial Discount Rates
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 referred to as 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 to 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.
But don’t forget that with a discounted ARM, your initial payment will probably remain at $476.95 for only 12 months, and that 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. In fact, if you buy a home using this kind of loan, you run the risk of . . .
Payment shock
Payment shock may occur if your mortgage payment rises very sharply at the first adjustment. Let’s see what would happen in the second year if the rate on your discounted 8% ARM were to rise to the 10% “standard” rate.
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ARM Interest Rate |
Monthly Payment |
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1st year (w/discount) @ 8% |
$ 476.95 |
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2nd year @ 10% |
$ 568.82 |
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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%.
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ARM Interest Rate |
Monthly Payment |
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1st year (w/discount) @ 8% |
$ 476.95 |
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2nd year @ 12% |
$ 665.43 |
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That’s 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.
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This information has been prepared to help you make the important decisions involved in buying and financing your home. However it should not be viewed as all inclusive OR as a replacement for professional advice. Talk with attorneys, mortgage lenders, real estate agents, and other advisers for information about lending practices, mortgage instruments, and your own interests before you commit to a specific loan or action.
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