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Adjustable-Rate Mortgages (ARMs)
Discounts and Payment Shock

 

Discounts

Some lenders offer initial adjustable-rate mortgage (ARM) rates that are lower than their "standard" ARM rates (lower than the sum of the index and the margin). Such rates, called discounted rates, are often combined with large initial loan fees ("points") and with much higher rates after the discount expires.

Very large discounts are often arranged by the seller. The seller pays an amount to the lender so that the lender can give you a lower rate and lower payments early in the mortgage term. This arrangement is called a "seller buydown." The seller may increase the sales price of the home to cover the cost of the buydown.

A lender may use a low initial rate to decide whether to approve your loan, based on your ability to afford it. You should be careful and consider whether you will be able to afford payments in later years when the discount expires and the rate is adjusted.

Here is how a discount might work. Let's assume that the lender's "standard" one-year ARM rate (index rate plus margin) is currently 10%, but your lender is offering an 8% rate for the first year. With the 8% rate, your first-year monthly payment would be $476.95. After the first 12 months, however, you run the risk of payment shock.

Payment Shock

Payment shock may occur if your mortgage payment rises very sharply at the first adjustment. Don't forget that with a discounted ARM, any savings during the discount period may be made up during the life of the mortgage or may be included in the price of the house.

Let us see what would happen in the second year if the rate on your discounted 8% ARM were to rise to the 10% "standard" rate.

  

ARM Interest Rate

Monthly Payment

  

1st year (w/discount) @ 8%

$ 476.95

  

2nd year @ 10%

$ 568.82

As the example shows, even if the index rate were to stay the same, your monthly payment would go up from $476.95 to $568.82 in the second year.

Suppose that the index rate increases 2% in one year and the ARM rate rises to 12%.

  

ARM Interest Rate

Monthly Payment

  

1st year (w/discount) @ 8%

$ 476.95

  

2nd year @ 12%

$ 665.43

That is an increase of almost $200 in your monthly payment. You can see what might happen if you choose an ARM because of a low initial rate. You can protect yourself from large increases by looking for a mortgage with features, described next, that may reduce this risk.

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