Mortgage Blog

Here’s a blog I found today. I am Facing Foreclosure .com. It should be required reading for anyone psyched up after a Carlton Sheets seminar.

Adjustable Rate Mortgages (ARMs) can be intimidating to new borrowers, but should not be overlooked. The key is to understand the variables involved, and then scrub them against your short/long term goals.

ARM’s feature an interest rate that can change. Lender’s offer superior rates on ARMs compared to fixed rate loans because they are not locked into providing the exact same rate to you for the next 30 or so years. ARM’s let the lender adjust according to market conditions and inflation. When interest rates go up, your ARM can go up as well. Comparing the difference between ARM’s is more complicated than fixed rate loans because the start rate is only important until the rate begins to change. How much it can change, and when it will change are just as important to consider.

The period of time between when your rate can change is the first variable to consider. Some ARM’s can actually change every single month, starting in the next month after you close. Ever here those 1% ads on the radio? It’s likely tied to a loan that changes monthly. It’s more common for an ARM to change once a year, and in many cases, it will have a period of a fixed rates for a few years before it becomes adjustable. For instance, a 5/1 ARM is fixed at the start rate for the first five years, then adjusts yearly. A 3/1 ARM is fixed for three years, then adjusts yearly. If you are pretty confident that you are going to move again in the next five years, a 5/1 has almost no downside to it.

How much your loan can adjust, once the fixed period is over, is the second variable to consider. ARM’s have caps that limit how much the rate can move at one time. Let’s say your caps are 2 & 5. That means the rate can adjust as much as two percent a year (assuming your loan only adjusts once a year), and can never go above 5% over your original start rate. With a 5/1 ARM and 2&5 caps, in a worse case scenario, your rate would change as follows.

Year One - Start Rate, let’s say it is 5%
Year Two though Five- 5%
Year Six - 7%
Year Seven - 9%
Year Ten - 10%
10 through 30 - 10%

Obviously, if you plan to live in a home for the next 30 years, with no intention of ever refinancing, an ARM like this may be a bad idea. But most folks would refinance or sell by the seventh year.

That’s a worse case scenario. Now let’s look at how the rates will actually adjust. It might seem like the start rate is the only important number to consider here, but that’s a mistake. The MARGIN plays the biggest role in how much your rate can change. Margin is one of those obscure figures that many loan companies try to breeze over. Always look at the margin if you think it’s possible that you’ll have this mortgage once it starts adjusting. So what is margin? It’s a set number that gets added to an index, to determine what your rate will be. This is where it gets tricky, but stay with me.

Different ARM’s are based on economical standards called indexes. One index is the Monthly Treasury Average (MTA). Another is the London Inter-bank Offered Rate (LIBOR). Many loans are based on US Treasury Bills. We could spend a day talking about indexes, but the simplified core of it is that these indexes go up and down, depending on the market. In times of higher rates, these indexes are higher. Some move up and down faster than the others, but they all pretty much mimic the economy. Currently, US Treasuries are about 5%.

Here’s where the margin kicks in. When your rate starts to adjust, the margin is added to whatever the index is at the time, and that is your new rate. Let’s use that same 5/1 ARM above and assume that your five years are up today. Let’s also assume that your margin is 1.875%

Start Rate was 5%, 2&6 Caps
Margin - 1.875%
Current Index - 5%
Index + Margin - 6.875%

For the next year, 6.875% is your new rate. Now lets assume the Treasury Index goes up to to 7.5% next year.

Current Rate 6.875%, 2&6 Caps
Margin - 1.875%
Current Index - 7.5%
Index + Margin -9.375%
Current Rate + 2% Cap 8.875%

In this case 8.875% would be your new rate because the caps limit the rate from going higher.

ARMs don’t just go up. If the index goes lower, so do your rates. It’s also important to remember that different loan companies will offer loans based on the same index. Again, the import number to consider in this case is the margin. Lenders will pay brokers for loans with higher margins. As you can see above, the difference between a 1% or 2% margin directly results in a 1% or 2% increase in your rate when the loan starts adjusting. In most cases, brokers can offer more than one margin, make sure you include this factor in your comparison.

Readers of this blog are likely the inquisitive sort, and have heard from more than a few consumer web sites about Yield Spread Premium. It’s popular these days to link the terms YSP and evil, greedy, or corrupt, but the reality is that YSP is a part of nearly every loan, from good brokers and bad. Your level headed understanding of why it exists will help you negotiate the best deal for you, regardless of wether or not a YSP exists on your loan.

Let’s start at the beginning. A mortgage broker is like an independent insurance agent. They work with several different lenders, each catering to different client bases. Some lenders specialize in high loans amounts, some in FHA & Fannie Mae “vanilla” loans, some in higher risk borrowers. Most of the time, many different lenders are competing for the same borrowers. Just how aggressively they wish to compete can vary from day to day. For this reason, most lenders publish a rate sheet at least once every day. A rate sheet is just a big price list of all the loans the lender offers and what they cost. Lenders charge the broker (and therefore the borrower) for lower rates on any particular program. Lenders also PAY brokers for higher rates. They pay even more for even higher rates. This payment from the lender to the broker is the Yield Spread Premium. To understand this better, lets look at a snippet from a random rate sheet.*

This is a very simplified example of what a broker is looking at. For this example, these rates are for a FNMA (Fannie Mae) fixed rate loan. This is the most common and basic loan in the industry. Two different terms are available; 30 years & 15 years. Lets look at the 30 year fixed loan in the left square. The first column is the interest rates that the lender is offering. The next four columns show how much the lender will pay/charge for these rates, depending on the lock period. A broker can choose from a 15 day lock to a 60 day lock. The loan has to fund between the time the broker locks, and the lock term expires. The most common lock period is 30 days, so let’s look at the third column. As you can see, I circled the Par Rate at 5.875% (0.000). The Par Rate is a wash. The lender neither charges nor pays to lock in this rate. If you wanted a 5.75% interest rate, the lender is charging 0.625 points. 1 point equals 1% of the loan amount. On a $100,000 loan amount, 1.000 equals $1,000. In this case, 0.625 points equals $625. The math works the same going the other way. If the broker locks you in a 5.875%, they earn 0.500 points, or $500 on that same $100,000 loan. They’d earn $2375 on a $100,000 loan if they locked you in at 6.5%.

I can see the steam coming out of your ears as you consider that somebody could actually earn an extra $2300 on top of all the other closing costs and origination fees for your loan. This has happened, maybe even to you, but step back and take a deep breath, there’s more to the story. A high YSP like this is often used to pay the borrower’s closing costs. When you here those ads on the radio about “no cost loans“, they use the YSP to fund all of those costs. Brokers may collect a YSP on smaller loan amounts. It’s just as hard to do a $80,000 loan as it is to do a $375,000 one.

Also remember that these are wholesale rates. That means (for hypothetical example) the rate that Countrywide Retail offers to you, the borrower, is not as low as the ones Countrywide Wholesale offers through a broker. Why? Because they don’t have to pay for the marketing and labor costs that the broker assumes in generating these loans. The Countrywide loan officer may be warning you to watch out for brokers and their evil YSP, but if he is offering a 6.125% loan at “par”, and the broker is offering you a 6.000% loan, and earning that 0.500 YSP, does it really matter who’s making what? The point is to look for the best deal, not who’s charging a YSP, and who isn’t

Some thing else to consider. I’m actually a Mortgage BANKER, not a Broker. That means my company will fund loans to you, then turn right around and sell them to lenders. By operating this way, I don’t even have to disclose that I’m earning a YSP (I do anyway), and can even earn an addition sum called a Service Release Premium that is based on total volume of loans delivered over a given month. Brokers, on the other hand are required by law to disclose this YSP on the HUD-1 Settlement Statement that you sign at closing. Because Bankers like myself can conceal this extra income, many of them are the ones yelling the loudest about how brokers must be screwing you because they earn this “kick-back” while they are as pure as the driven snow.

Face it. It’s unlikely that you will know just how much profit is being harvested on any given loan. But think about it. Do you know how much profit your insurance agent makes on you? Do you know how much profit Starbucks made on the latte’ you’re sipping? Does it really matter? I say no. What matters to me is, who is giving me the best deal. If you want the best deal on a mortgage loan, you need to stop worrying about how much everyone is making, and focus on what YOU are paying.

So, my longest post ever explains a component of this industry that is largely a distraction to the bottom line. Here’s what’s important. What are your closing costs? What is your interest rate? What’s the APR?

APR, not YSP is the one simple number that determines who is giving you the best deal.

Check out my post APR Simplified for details.

*These numbers are just for hypothetical ponderings. The example I pulled is not up to date, nor does it display several other adjustments for things like occupancy and loan to value.