What is an Annual Percentage Rate
A tool used to compare loans across different lenders is the Annual Percentage Rate (APR). The Federal Truth in Lending law requires mortgage companies to disclose the APR when they advertise a rate. It is designed to represent the true cost of the loan to the borrower, expressed in the form of a yearly rate. The purpose is to prevent lenders from hiding fees and upfront costs behind low advertised interest rates.
One confusing aspect of APRs is that the APR on 15 year loans will carry a higher relative rate due to the fact that the points are amortized over the 15 year term rather than the 30 year term. When a Regulation Z (the mortgage companies disclosure of cost for the loan) is prepared for a buyer/borrower the prepaid interest is also included in the APR calculation.
Even lenders admit it is confusing since it includes some, but not all, of the various fees and insurance premiums that accompany a mortgage. The rules for calculation of this number have not been clearly defined, so APRs vary from lender to lender and from loan to loan, depending on which types of fees and charges are included.
In addition, the APR model is flawed in that when a product is variable and tied to a market index, the index is assumed to never change. This obviously is an invalid assumption that can lead again to a number, which in fact can not be compared, from one quoting source to another.
Finally, the APR won't tell you anything about balloon payments and prepayment penalties and how long your rate is locked for. You can use APRs as a guideline to shop for loans, but you should not depend solely on the APR in choosing which loan is best for your needs.
Adjustable Rate Mortgages (ARM)
These loans generally begin with an interest rate that is 2-3 percent below a comparable fixed rate mortgage, and could allow you to buy a more expensive home.
However, the interest rate changes at specified intervals (for example, every year) depending on changing market conditions; if interest rates go up, your monthly mortgage payment will go up, too. However, if rates go down, your mortgage payment will drop also.
There are also mortgages that combine aspects of fixed and adjustable rate mortgages - starting at a low fixed-rate for seven to ten years, for example, then adjusting to market conditions. Ask your mortgage professional about these and other special kinds of mortgages that fit your specific financial situation
Interest Rate Buydowns
The most common buydown is the 2-1 buydown. In the past, for a buyer to secure a 2-1 buydown they would pay 3 points above current market points in order to pay a below market interest rate during the first two years of the loan. At the end of the two years they would then pay the old market rate for the remaining term.
As an example, if the current market rate for a conforming fixed rate loan is 8.5% at a cost of 1.5 points, the buydown gives the borrower a first year rate of 6.50%, a second year rate of 7.50% and a third through 30th year rate of 8.50% and the cost would be 4.5 points. Buydown were usually paid for by a transferring company because of the high points associated with them.
In today's market, mortgage companies have designed variations of the old buydowns rather than charge higher points to the buyer in the beginning they increase the note rate to cover their yields in the later years.
As an example, if the current rate for a conforming fixed rate loan is 8.50% at a cost of 1.5 points, the buydown would give the buyer a first year rate of 7.25%, a second year rate of 8.25% and a third through 30th year rate of 9.25% , or a three-quarter point higher note rate than the current market and the cost would remain at 1.5 points.
Another common buydown is the 3-2-1 buydown which works much in the same ways as the 2-1 buydown, with the exception of the starting interest rate being 3% below the note rate. Another variation is the flex-fixed buydown programs that increase at six month interval rather than annual intervals.
As an example, for a flex-fixed jumbo buydown at a cost of 1.5 points, the first six months rate would be 7.50%, the second six months the rate would be 8.00%, the next six months rate would be 8.50%, the next six months rate would be 9.00%, the next six months the rate would be 9.50% and at the 37th month the rate would reach the note rate of 9.875% and would remain there for the remainder of the term. A comparable jumbo 30 year fixed at 1.5 points would be 8.875%
Graduated Payment Mortgage (GPM)
The GPM is another alternative to the conventional adjustable rate mortgage, and is making a comeback as borrowers and mortgage companies seek alternatives to assist in qualify for home financing
Unlike an ARM, GPMs have a fixed note rate and payment schedule. With a GPM the payments are usually fixed for one year at a time. Each year for five years the payments graduate at 7.5% - 12.5% of the previous years payment.
GPMs are available in 30 year and 15 year amortization, and for both conforming and jumbo loans. With the graduated payments and a fixed note rate, GPMs have scheduled negative amortization of approximately 10% - 12% of the loan amount depending on the note rate. The higher the note rate the larger degree of negative amortization. This compares to the possible negative amortization of a monthly adjusting ARM of 10% of the loan amount. Both loans give the consumer the ability to pay the additional principal and avoid the negative amortization. In contrast, the GPM has a fixed payment schedule so the additional principal payments reduce the term of the loan. The ARMs additional payments avoid the negative amortization and the payments decrease while the term of the loan remains constant.
The scheduled negative amortization on a GPM differs depending on the amortization schedule, the note rate and the payment increases of the loan. GPM loans with 7.5% annual payment increases offer the lowest qualifying rate but the largest amount of negative amortization.
On a loan of $150,000, with a 30 year amortization and a note rate of 10.50% with 12.5% annual payment increases, the negative amortization continues for 60 months. The qualifying rate is 5.75% and the negative amortization is 11.34% (approximately $17,010).
The note rate of a GPM is traditionally .5% to .75% higher than the note rate of a straight fixed rate mortgage. The higher note rate and scheduled negative amortization of the GPM makes the cost of the mortgage more expensive to the borrower in the long run. In addition, the borrowers monthly payment can increase by as much as 50% by the final payment adjustment.
The lower qualifying rate of the GPM can help borrowers maximize their purchasing power, and can be useful in a market with rapid appreciation. In markets where appreciation is moderate, and a borrower needs to move during the scheduled negative amortization period they could create an unpleasant situation.
London InterBank Offered Rate (LIBOR)
LIBOR is the rate on dollar-denominated deposits, also know as Eurodollars, traded between banks in London. The index is quoted for one month, three months, six months as well as one-year periods.
LIBOR is the base interest rate paid on deposits between banks in the Eurodollar market. A Eurodollar is a dollar deposited in a bank in a country where the currency is not the dollar. The Eurodollar market has been around for over 40 years and is a major component of the International financial market. London is the center of the Euromarket in terms of volume.
The LIBOR rate quoted in the Wall Street Journal is an average of rate quotes from five major banks. Bank of America, Barclays, Bank of Tokyo, Deutsche Bank and Swiss Bank.
The most common quote for mortgages is the 6-month quote. LIBOR's cost of money is a widely monitored international interest rate indicator. LIBOR is currently being used by both Fannie Mae and Freddie Mac as an index on the loans they purchase.
LIBOR is quoted daily in the Wall Street Journal's Money Rates and compares most closely to the 1-Year Treasury Security index.
