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PAY OPTION ARMS GLOSSARY
Amortized Payments:
This is a payment based on the repayment of principal and interest. No negative amortization on amortized payments, your balance actually goes down.
Effective Rate:
Effective rate (real interest rate) is your index plus your margin.
Indexes:
MTA - The most common index used is the MTA. Here is the description: "The 12-Month Treasury Average Index (12-MTA) is based on the average annual yields on U.S. Treasury Securities adjusted to a constant maturity of one year, as made available by the Federal Reserve. The 12 months average is determined by adding together the annual yields for the most recently available 12 months and dividing by 12."
COST OF SAVINGS INDEX - COSI - This index is very stable and slow moving ("that's good"). Historically, COSI does not move up or down as rapidly as other market interest rates such as the treasury, LIBOR, or the prime rate. This means that you are protected from any sharp changes in the market.
Interest Only:
When you make the interest payment you will NOT have any negative amortization. You will not pay down the principal but you will not add to it. So, here is what you need to know about this: The difference between your minimum payment and the interest payment is your negative amortization. Yes, if you make the minimum payment the difference is what is added to your loan balance. Lenders like to call it "deferred interest" on the statement. I guess they think it will not be noticed. What would the borrower think if they put "negative amortization" on the statement? You got it.
Loan Term:
The most common is for 5 years although there are some that extend up to 10 years.
Margin:
This is the biggie as it sets your effective rate (the real interest rate). Here is the description: "The number of percentage points (for example, 3.5) the lender adds to the index rate to calculate the ARM interest rate at each adjustment. The margin is set in the mortgage contract; remains fixed for the term of the loan and are not impacted by the financial markets and movement of interest rates." Okay here is what you need to know. Index plus margin is your true interest rate. So for example, the MTA right now is at 4.14* and if your margin is at 3.5 then your effective interest rate is 7.64!
Minimum Payment:
Ahh, the minimum payment. This is the payment based on the start rate, normally 1% although lenders are beginning to push up the start rate a little bit. Here is what you need to know: The minimum payment does not cover the interest payment due on the loan. Did you guess negative amortization? If you did, you are right!
Negative Amortization:
By now you should know what this is but in case you forgot here it is again. Negative amortization occurs when you make the minimum payment. The amount of negative amortization is the difference between your minimum payment and the interested only payment. This amount is added to your loan balance. Lenders show this on your statement as "deferred interest."
Payment Cap:
Normally the option arm has a 9.95% payment can although some have an 11.95% payment cap. Basically this means that the effective interest (real interest rate) rate can go up to those caps. You remember the effective interest rate don't you? Very rare for this to occur because of the following component to an option arm.
Payment Options:
Typically you will see four payment options after the first month. The minimum payment, the interest payment and a 15-year and 30-year amortized payment.
Prepayment Penalty:
This type of loan typically has a 3 year prepayment penalty although you can find them with 1 year and in some cases without a prepayment penalty. Loan officers usually do not disclose these options.
Recast Clause:
Okay now you are reading insider secrets so pay close attention to this: The recast clause says that if your loan balance goes up to a certain amount over your original loan amount that the loan can recast to a fully indexed rate. What this means is that potentially you can be going along with your option arm happily making your minimum payments and then you receive a notice saying your loan has recast and your minimum payment is not your minimum payment anymore — it is now the fully indexed rate payment! The payment can go up dramatically! Usually the recast amount is 110% of the original loan amount although some lenders offer a higher recast amount. No loan officer will ever tell you or make you aware of this recast clause.
Yearly Increase:
This one is pretty simple. Your minimum monthly payment will increase 7.5% after each 12 months and remain constant for the following 12 months until the next adjustment period. So, your payment goes up once per year. So, if your payment (excluding taxes and insurance) is $800 per month your yearly increase would be $60.
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