As published in Scotsman Guide's Residential Edition, November 2005.
Advertisements for low introductory rates for mortgage loans abound in newspapers, in direct mail, on radio, on the Internet and elsewhere. These low rates seem unbeatable and can excite and entice borrowers -- but these programs can be detrimental to the livelihood, investment and future of some borrowers.
As a mortgage professional, an essential way for you to build and maintain credibility with customers is to fully understand all programs, particularly the eye-catching interest-only and teaser-rate ARMs that have recently risen in popularity. Borrowers, especially those who are uninformed, look to their mortgage professional to help them decipher industry jargon and to determine if these loans are right for them.
Let's take a closer look at a few of these ARMs. Loan officers who offer a one-year ARM can help their borrowers understand that the interest rate will change every year. But when borrowers hear about a 1-percent, one-year ARM offer, they cannot believe it. Because the public has been taught that lower interest rates are better, these borrowers may be compelled to request the low-rate product. How different could the terms be?
In this case, the terms are quite different. A one-year ARM offers an interest rate that is fixed for one year. The 1-percent, one-year ARM, on the other hand, offers payments that are fixed at the 1-percent level, but this does not reflect the fact that the underlying interest rate is changing. The introductory-rate and subsequent payment-rate changes are based on the payment rate, not the interest rate. The deficit between the payment rate and the actual interest-rate-carrying cost on the loan can result in principal being added back to the loan -- known as negative amortization.
A borrower's loan balance may increase far more dramatically with deferred interest than it will decrease with amortization. This is because negative amortization is compounded interest -- interest on interest. While this may not be horrific in and of itself, this is what happen when interest rates increase only moderately, at the rate of 1 percent per year. In today's rising short-term interest-rate environment, rates are likely to rise much more rapidly than that, adding more to the loan balance.
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