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Refinance with Minimum Payments & Fixed Rates

By Tristan Hunt Published 12/29/2006 | Real Estate

With all of the options available to homeowners today, adjustable rate financing is a common topic of discussion at our offices.  The 3 most popular Adjustable Rate Mortgage (ARM) types today are Hybrid ARMs, Option ARMs, and Hybrid Option ARMs.  Sound pretty similar don't they?  There are similarities, that's for sure, but there are differences as well.

Hybrid ARMs

Hybrid ARMs are a cross between a traditional fixed rate mortgage and a classic ARM.  They generally come in varieties indicating how long they are fixed for, and how often they adjust thereafter.  For example, a 3/1 ARM will have a fixed rate for the first 3 years, and can then adjust once every year thereafter.  A 2/1 would be fixed for years and adjust every year thereafter, a 5/1 fixed for five years, 7/1 for seven and a 10/1 for ten. 

All adjustable rate mortgages are calculated using an index, such as the MTA, the COFI, the COSI or the LIBOR.  MTA and LIBOR are most popular. These rates indicate a basic borrowing cost of capital for the lender, this is how much it costs them to lend money in a perfect world.  They also have a margin, which is like a risk premium, their profit for making the loan. 

Hybrid ARMs have basic characteristics including:

1. Start Rate which remains fixed for X amount of time, so a 3/1 lasts 3 years and adjusts every year thereafter

2. Adjustment Cap Structure which dictates how much the rate can change when the loan begins adjusting. A 5/1/5 adj. cap structure means that the 1st time the rate adjusts it can go up or down 5 points max, any subsequent adjustments are limited to 1 point up or down, and the rate can never go up or down more than five points.

3. Floor: a rate which the note rate or fully indexed rate can never be lower than. (usually the initial fully indexed rate)

4. Ceiling: a rate which the note rate or fully indexed rate can never go higher than (usually 9.95 to 11.95 depending on lender and index)

The minimum payment on a 100,000 dollar regular Hybrid ARM with a 7% rate would be a bit over 665.00 dollars, and borrowers of all credit levels qualify for Hybrid ARM type mortgages.

One Month Option ARM

Option ARMs are one of the most popular loan types in today's market, and for good reason.  Option ARMs are like regular ARMs, but they have 4 payment options instead of just the one fully amortized payment option on a regular mortgage.  The minimum payment option is the main point of attraction for majority of the Option ARM customers in the USA today, because it allows them to make smaller payments when cash is tight.  The minimum payment for the initial period of the loan for 100,000 dollars would be 322 dollars, versus 665 dollars for the full payment on a conventional mortgage.  A great option for the self employed, the small business owner.

On 1 month option arms, they adjust every month after the initial period, so if the initial period is 6 months or 1 year, then every month therafter the rate adjusts.  There are 6 month and 1 year option arms wherein the payment adjusts every 6 months or 1 year thereafter as well, however 1 mo arms are most popular.  They have additional features in addition to standard Hybrid ARMs:

6. A Minimum Payment: a payment which like a credit card allows you to stay current on the mortgage without paying the full amount of interest due, referred to as deferring interest

7. A Minimum Payment Adjustment Cap: the maximum amount that the minimum payment AMOUNT can increase or decrease in a given period. Typically 7.5%. So if your minimum payment is 1000 dollars, then in the next period it can not go higher than 1075 dollars.

8. A Negative Amortization Cap: This is the maximum the loan balance is allowed to increase due to deferral of interest (making the minimum payment only) before the loan is re-cast and the minimum payment option goes away.  Depending on state and LTV this is 110% to 120% of the loan amount.

Option ARM Example: On a 100,000 Option ARM with a 1% start rate, a base or index rate of 4% and a margin of 4%,

      - Min Payment   = 322

      - Interest Only   = 667

      - Deferred Int.   = 345 (IO minus Min Pay)

      - 1 Yr Neg. Am. = 4140

      - Recast Point   = 115000 (assuming 115% neg-am cap)

      - Recast Month  = 43 (assuming you only make the minimum payment)

When a regular option arm exceeds its negative amortization cap and recasts (typically in 3 and half to 4 years if you're only making the minimum payment) the minimum payment option goes away, and you are left with the fully amortizing payment, although some products are beginning to extend the availability of the interest only option for up to 10 years.  Because of the incredible flexibility of these loans, they are limited to higher credit borrowers (generally a FICO score of 660 is required, however certain programs are available for borrowers with FICOs of 600 or better).

Hybrid Option ARMs or Fixed Rate Option ARMs

Hybrid Option ARMs combine some the best features of Hybrid ARMs, such as medium term fixed rates, with the best aspects of Option ARMs, such as low minimum payments, while solving a lot of the problems with both for the average borrower. They are most popular with homeowners who want the stability of a fixed rate mortgage but the option to make very, very low minimum payments, and are considered an ideal compromise between "safety" and "flexibility" in the mortgage world.

Hybrid Option ARMs are generally based on normal Hybrid ARMs, in that their initial period is usually 3/1, 5/1, 7/1 or 10/1 meaning 3, 5, 7 or 10 years where the rate and minimum payment stays fixed, and 1 adjustment per year afterwards.

However they have Option ARM like features such as a minimum payment, minimum payment adjustment cap, and neg am cap.

Using the above example the same loan amount in a typical hybrid option arm package

      - Min Payment   = 449 (assuming 3.5%)

      - Interest Only  = 583

      - Deferred Int.   = 134 (1/3 of regular option arm)

      - 1 Yr Neg. Am. = 1608

      - Recast Point   = 115000 (assuming 115% neg-am cap)

      - Recast Month = 112 (assuming you only make the minimum payment)

Also, when hybrid option arms recast, most of them allow for an Interest Only option instead of forcing the borrower into a fully amortized payment they might not be able to afford.  Along with the long recast timeframes and the fixed rates for the initial period, this substantially reduces payment shock on recast.

Wrapping Up

So we've discussed Hybrid ARMS, Option ARMs, and Hybrid Option ARMs, and will provide a variety of real world examples and detailed treatment of relevant topics in other articles in this series.  And as always we welcome your questions and calls.