Julie Garton-Good writes in her 2008 book "All About Mortgages" that PMI (private mortgage insurance) can allow you to buy a more expensive home (by as much as 40%).
The cost is usually less than .5% of the loan amount.
"Although the buyer typically bears the cost of PMI, the lender is the PMI company’s client and shops for the PMI on behalf of the borrower."
PMI typically covers only first mortgages on owner-occupied housing. Some PMI insurers will take on second-mortgages, but you’ll have to pay bigger premiums.
In the worst housing slump since the Great Depression, 67,967 homeowners with mortgage insurance fell at least 60 days behind on their loans, compared with 40,687 who got back on track, the Mortgage Insurance Companies of America reported today. The housing slump has led to record losses for the insurers that supply the trade group’s data. Share Declines The biggest mortgage insurer, MGIC Investment Corp. declined by about 89 percent in 12 months in New York Stock Exchange composite trading. No. 2 PMI Group Inc. and No. 3 Radian Group Inc.plunged more than 95 percent. MGIC fell 88 cents, or 13 percent, to $6.11 at 4:03 p.m., while PMI dropped 40 cents, or 17 percent, to $1.95 and Radian gained 2 cents to $1.45. Genworth, which also sells life insurance, lost 18 cents to $17.81. Insurers are tightening standards on mortgages they cover to stem further losses. The Mortgage Insurance Companies of America data are drawn from six of the seven largest U.S. mortgage insurers, excluding non-member Radian, causing an understatement of the total number of defaults.
PMI companies look at the same questions as lenders. As well as these questions (giving the wrong answer raises a red flag):
* Is it feasible that the borrower can meet any payment increases in the loan?
* Does the loan have a discount teaser rate?
* Are there increased interest and payments later?
* Is the loan-to-value ratio high?
* How much cash does the borrower have?
* Is the economy of the area sound?
* Is there an oversupply of housing in the area?
* How stable is the borrower’s employment?
Blue-collar workers typically have higher rates of default.
The first adjustable-rate mortgages (ARM) in the early 1980s were really renegotiable rate mortgages (RRM). Because of high inflation and interest rates, many borrowers could not qualify for the higher loan rates and had to default or sell.
Today’s ARMs usually have interest-rate caps, strong secondary mareket undewriting guidelines and mandatory rate disclosure regulations.
An adjustable rate mortgage (ARM) is a mortgage loan where the interest rate on the note is periodically adjusted based on a variety of indices. Among the most common indices are the rates on 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR). A few lenders use their own cost of funds as an index, rather than using other indices. This is done to ensure a steady margin for the lender, whose own cost of funding will usually be related to the index. Consequently, payments made by the borrower may change over time with the changing interest rate (alternatively, the term of the loan may change). This is not to be confused with the graduated payment mortage, which offers changing payment amounts but a fixed interest rate. Other forms of mortgage loan include the interest only mortgage, the fixed rate mortgage, the negative amortization mortgage, and the balloon payment mortgage. Adjustable rates transfer part of the interest rate risk from the lender to the borrower. They can be used where unpredictable interest rates make fixed rate loans difficult to obtain. The borrower benefits if the interest rate falls and loses out if interest rates rise.
Adjustable rate mortgages are characterized by their index and limitations on charges (caps). In many countries, adjustable rate mortgages are the norm, and in such places, may simply be referred to as mortgages.
All adjustable rate mortgages have an adjusting interest rate tied to an index.
In Western Europe, the index may be the TIBOR or Euro Interbank Offered Rate (EURIBOR).
Six common indices in the United States are:
- 11th District Cost of Funds Index (COFI)
- London Interbank Offered Rate (LIBOR)
- 12-month Treasury Average Index (MTA)
- Constant Maturity Treasury (CMT)
- National Average Contract Mortgage Rate
- Bank Bill Swap Rate (BBSW)
In some countries, banks may publish a prime lending rate which is used as the index. The index may be applied in one of three ways: directly, on a rate plus margin basis, or based on index movement.
A directly applied index means that the interest rate changes exactly with the index. In other words, the interest rate on the note exactly equals the index. Of the above indices, only the contract rate index is applied directly.
To apply an index on a rate plus margin basis means that the interest rate will equal the underlying index plus a margin. The margin is specified in the note and remains fixed over the life of the loan. For example, a mortgage interest rate may be specified in the note as being LIBOR plus 2%, 2% being the margin and LIBOR being the index.
The final way to apply an index is on a movement basis. In this scheme, the mortgage is originated at an agreed upon rate, then adjusted based on the movement of the index. Unlike direct or index plus margin, the initial rate is not explicitly tied to any index; the adjustments are tied to an index.
Basic features of ARMs
The most important basic features of ARMs are:
- Initial interest rate. This is the beginning interest rate on an ARM.
- The adjustment period. This is the length of time that the interest rate or loan period on an ARM is scheduled to remain unchanged. The rate is reset at the end of this period, and the monthly loan payment is recalculated.
- The index rate. Most lenders tie ARM interest rates changes to changes in an index rate. Lenders base ARM rates on a variety of indices, the most common being rates on one-, three-, or five-year Treasury securities. Another common index is the national or regional average cost of funds to savings and loan associations.
- The margin. This is the percentage points that lenders add to the index rate to determine the ARM’s interest rate.
- Interest rate caps. These are the limits on how much the interest rate or the monthly payment can be changed at the end of each adjustment period or over the life of the loan.
- Initial discounts. These are interest rate concessions, often used as promotional aids, offered the first year or more of a loan. They reduce the interest rate below the prevailing rate (the index plus the margin).
- Negative amortization. This means the mortgage balance is increasing. This occurs whenever the monthly mortgage payments are not large enough to pay all the interest due on the mortgage. This may be caused by the payment cap contained in the ARM when are high enough that the principal plus interest payment is greater than the payment cap.
- Conversion. The agreement with the lender may have a clause that allows the buyer to convert the ARM to a fixed-rate mortgage at designated times.
- Prepayment. Some agreements may require the buyer to pay special fees or penalties if the ARM is paid off early. Prepayment terms are sometimes negotiable.
It should be obvious that the choice of a home mortgage loan is complicated and time consuming. As a help to the buyer, the Federal Reserve Board and the Federal Home Loan Bank Board have prepared a mortgage checklist.
Limitations on charges (caps)
Any mortgage where payments made by the borrower may increase over time brings with it the risk of financial hardship to the borrower. To limit this risk, limitations on charges—known as caps in the industry—are a common feature of adjustable rate mortgages. Caps typically apply to three characteristics of the mortgage:
- frequency of the interest rate change
- periodic change in interest rate
- total change in interest rate over the life of the loan, sometimes called life cap
For example, a given ARM might have the following types of caps:
Interest rate adjustment caps:
- interest adjustments made every 6 months, typically 1% per adjustment, 2% total per year
- interest adjustments made only once a year, typically 2% maximum
- interest rate may adjust no more than 1% in a year
Mortgage payment adjustment caps:
- maximum mortgage payment adjustments, usually 7.5% annually on pay-option/negative amortization loans
Life of loan interest rate adjustment caps:
- total interest rate adjustment limited to 5% or 6% for the life of the loan.
Caps on the periodic change in interest rate may be broken up into one limit on the first periodic change and a separate limit on subsequent periodic change, for example 5% on the initial adjustment and 2% on subsequent adjustments.
Although uncommon, a cap may limit the maximum monthly payment in absolute terms (for example, $1000 a month), rather than in relative terms.
ARMs that allow negative amortization will typically have payment adjustments that occur less frequently than the interest rate adjustment. For example, the interest rate may be adjusted every month, but the payment amount only once every 12 months.
Cap structure is sometimes expressed as initial adjustment cap / subsequent adjustment cap / life cap, for example 2/2/5 for a loan with a 2% cap on the initial adjustment, a 2% cap on subsequent adjustments, and a 5% cap on total interest rate adjustments. When only two values are given, this indicates that the initial change cap and periodic cap are the same. For example, a 2/2/5 cap structure may sometimes be written simply 2/5.
ARMs generally permit borrowers to lower their initial payments if they are willing to assume the risk of interest rate changes. In many countries, banks or similar financial institutions are the primary originators of mortgages. For banks that are funded from customer deposits, the customer deposits will typically have much shorter terms than residential mortgages. If a bank were to offer large volumes of mortgages at fixed rates but to derive most of its funding from deposits (or other short-term sources of funds), the bank would have an asset-liability mismatch: in this case, it would be running the risk that the interest income from its mortgage portfolio would be less than it needed to pay its depositors. In the United States, some argue that the savings and loan crisis was in part caused by this problem, that the savings and loans companies had short-term deposits and long-term, fixed rate mortgages, and were caught when Paul Volcker raised interest rates in the early 1980s. Therefore, banks and other financial institutions offer adjustable rate mortgages because it reduces risk and matches their sources of funding.
Banking regulators pay close attention to asset-liability mismatches to avoid such problems, and place tight restrictions on the amount of long-term fixed-rate mortgages that banks may hold (in relation to their other assets). To reduce this risk, many mortgage originators will sell many of their mortgages, particularly the mortgages with fixed rates.
For the borrower, adjustable rate mortgages may be less expensive, but at the price of bearing higher risk. Many ARMs have "teaser periods," which are relatively short initial fixed-rate periods (typically one month to one year) when the ARM bears an interest rate that is substantially below the "fully indexed" rate. The teaser period may induce some borrowers to view an ARM as more of a bargain than it really represents. A low teaser rate predisposes an ARM to sustain above-average payment increases.
Here are the advantages of ARMs:
* Lower interest rates allow the buyer to qualify more easily for the loan
* Rates adjust based on inflation, making the loan equitable for borrower and lender
* The borrower can choose from various adjustable periods
* Some ARMs can be converted to fixed-rate mortgages
* Teaser rates drastically reduce payments in the first year of the loan
* ARMs are good for times of low inflation and for short-term ownership
* Some lenders keep ARMs in portfolio
Here are the disadvantages of ARMs:
* Interest rates will vary and the borrower may not be able to keep up with the payments
* The buyer may over-leverage, sucked in by the attractive teaser rate
* The loan may have a negative amortization clause, making resale more difficult
Here are the important components of an ARM:
* The lender’s profit margin
* Index that rises or falls depending on the economy, and this determines the interest rate
* Initial rate or teaser rate
* Note rate is the actual interest rate
* Adjustable period, the time when the interest rate can change, say, annually
* Interest rate caps
* Negative amortization: Occurs when a payment is insufficient to cover the interest on a loan. The shortfall is added to the principal balance
* Convertability aka the option to change to a fixed rate mortgage
How are rates set for an ARM? Rates are composed of two things — the index and the margin. The index is an inflation indicator and the margin is the cost of doing business for the lender. This formula determines the interest rate.
What’s a teaser rate? Just what it sounds. A way low interest rate for a year usually. Lenders use them to attract business. This is common sense. Can you handle the regular rate when it kicks in after a year? Do you anticipate higher income down the line to pay for higher mortgage payments? Will the property’s value increase enough to cover any negative amortization?
Lenders set their profit margin on the loan and it does not vary as interest rates go up and down.
"The index rate plus the margin combine to make the note or accrual rate, also called the fully indexed rate."
Lenders quote margins at anywhere from 1-4% points.
Lenders don’t like negative amortization. They limit how much can accrue on a loan, say 125% of the original loan balance. The lender can ask the borrower to make a cash payment to reduce the balance. They can extend the loan’s term. They can request larger payments.
Many ARMs offer a convertability option. You can convert to a fixed rate loan for a fee, usually between months 13 and 60. This fixed rate will usually be about a half percentage point higher than if you had purchased a fixed-rate loan at the beginning.
PMI shields lenders from most of the risk on ARMs. PMI is usually used to insure the lender from the borrower’s default on the top 20% of the loan.
PMI rates for ARMs can be as much as 25% higher than for fixed rate loans.
If you ask the lender to keep your ARM loan in portfolio, the lender may waive the PMI or self-insure.
In general, it is easier to qualify for an ARM mortgage. Equity in a higher-leveraged loan builds more slowly, and that increases the lender’s up-front risk on the loan.
Here are the normal standards for getting an ARM loan: A 90% loan-to-value loan with qualifying ratios of 28% housing debt and 36% long-term debt.
The two-step mortgage is a 30-year fixed rate loan with one rate adjustment.
The FHA’s ARM is a good deal. It has caps of 1% annually and 5% lifetime.
The program allows no negative amortization.
Surveys suggest that about 25% of all ARMs contain calculation errors.
If the borrower can save at least 2.5% interest using an ARM and will hold the property for less than four years, the ARM is probably a good deal.
Here are some questions to ask a lender before taking out an ARM:
* What is the history of the index used?
* Where do economists say rates are headed?
* What are the terms of the loan?
* What is the lender’s margin?
* Is there a convertability option?
* How long will the property be held?
* Will the ARM be assumable when the property is sold?
* What are the upfront costs of the loan?
* Will the lender hold the loan in portfolio?
A borrower should ask himself his goals in buying a property, how long does he plan to own it, how much of a down payment will he use, how much of a monthly payment can he afford?
A fixed rate mortgage (FRM) is a mortgage loan where the interest rate on the note remains the same through the term of the loan, as opposed to loans where the interest rate may adjust or "float." Other forms of mortgage loan include interest only mortgage, graduated payment mortgage, adjustable rate mortgage, negative amortization mortgage, and balloon payment mortgage. Please note that each of the loan types above except for a straight adjustable rate mortgage can have a period of the loan for which a fixed rate may apply. A Balloon Payment mortgage, for example, can have a fixed rate for the term of the loan followed by the ending balloon payment. Terminology may differ from country to country: loans for which the rate is fixed for less than the life of the loan may be called hybrid adjustable rate mortgages (in the United States).
This payment amount is independent of the additional costs on a home sometimes handled in escrow, such as property taxes and property insurance. Consequently, payments made by the borrower may change over time with the changing escrow amount, but the payments handling the principal and interest on the loan will remain the same.
Fixed rate mortgages are characterized by their interest rate (including compounding frequency, amount of loan, and term of the mortgage). With these three values, the calculation of the monthly payment can then be done.
If you put less than 20 percent down on a home mortgage, lenders often require you to have Private Mortgage Insurance (PMI). PMI protects the lender if you default on the loan. The Homeowners Protection Act of 1998 – which became effective in 1999 – establishes rules for automatic termination and borrower cancellation of PMI on home mortgages. These protections apply to certain home mortgages signed on or after July 29, 1999 for the purchase, initial construction, or refinance of a single-family home. These protections do not apply to government-insured FHA or VA loans or to loans with lender-paid PMI.
For home mortgages signed on or after July 29, 1999, your PMI must – with certain exceptions – be terminated automatically when you reach 22 percent equity in your home based on the original property value, if your mortgage payments are current. Your PMI also can be canceled, when you request – with certain exceptions – when you reach 20 percent equity in your home based on the original property value, if your mortgage payments are current.
One exception is if your loan is "high-risk." Another is if you have not been current on your payments within the year prior to the time for termination or cancellation. A third is if you have other liens on your property. For these loans, your PMI may continue. Ask your lender or mortgage servicer (a company that collects your payments) for more information about these requirements.
If you signed your mortgage before July 29, 1999, you can ask to have the PMI canceled once you exceed 20 percent equity in your home. But federal law does not require your lender or mortgage servicer to cancel the insurance.
On a $100,000 loan with 10 percent down ($10,000), PMI might cost you $40 a month. If you can cancel the PMI, you can save $480 a year and many thousands of dollars over the loan. Check your annual escrow account statement or call your lender to find out exactly how much PMI is costing you each year.
Additional provisions in the law
- New borrowers covered by the law must be told – at closing and once a year – about PMI termination and cancellation.
- Mortgage servicers must provide a telephone number for all their mortgage borrowers to call for information about termination and cancellation of PMI.
- Even though the law’s termination and cancellation rights do not cover loans that were signed before July 29, 1999, or loans with lender-paid PMI signed on any date, lenders or mortgage servicers must tell borrowers about the termination or cancellation rights they may otherwise have under those loans (such as rights established by the contract or state law).
Some states may have laws that apply to early termination or cancellation of PMI – even if you signed your mortgage before July 29, 1999. Call your state consumer protection agency for more information about your state’s rules. Fannie Mae and Freddie Mac, which buy home mortgages from lenders, also may have guidelines affecting termination or cancellation of PMI on home mortgages signed before July 29, 1999. Check with your lender or mortgage servicer, or call Fannie Mae or Freddie Mac, for more information.
Contact your lender or mortgage servicer to learn whether you’re paying PMI. If you are, ask how and when it can be terminated or canceled.
For More Information
The FTC works for the consumer to prevent fraudulent, deceptive, and unfair business practices in the marketplace and to provide information to help consumers spot, stop, and avoid them. To file a complaint or to get free information on consumer issues, visit ftc.gov or call toll-free, 1-877-FTC-HELP (1-877-382-4357); TTY: 1-866-653-4261. The FTC enters Internet, telemarketing, identity theft, and other fraud-related complaints into Consumer Sentinel, a secure online database available to hundreds of civil and criminal law enforcement agencies in the U.S. and abroad.