Today’s mortgage market includes very few of the exotic loans so prevalent in recent years.
“Option ARM,” “hybrid,” negative amortization,” “stated income,” “low doc” and “no doc” loans have virtually evaporated, some would say thankfully. The remaining field of mortgages is relatively tame and easier to understand. One less explored area concerns the basis of rate setting.
Home Equity Lines of Credit (HELOC’s and other short-term lending vehicles
The prime rate is the rate banks use to lend money to each other and is a commonly used, short-term interest rate. Many credit instruments such as home equity loans and lines of credit, automobile loans and credit card rates are based on this index and use it as a foundation rate for pricing various short-term loan products. When there is a change to the U.S. prime rate, any loan product that is tied to prime will also change. Providers of consumer and commercial loan products often use the U.S. prime rate as their base-lending rate, then add a margin (profit) based primarily on the amount of risk associated with a loan.
Adjustable Rate Mortgages
Rates for adjustable rate mortgages, or ARM’s, are based on a variety of indices that often reflect the prime rate, but are not strictly based on it. These economic indices include rates of shorter-term Treasury bills such as the one-year Treasury bill, the Cost of Funds Index, which is based on the national or regional average cost of funds to savings and loan associations and the London InterBank Offered Rate.
To arrive at a mortgage rate they will offer potential borrowers, lenders take these indices and add what is termed a margin or profit to the lender. The amount of the margin may differ from one lender to another, but it is usually constant over the life of the loan. For example, if the rate on an index were 3 percent and the lender added a margin of 2.5 percent, the rate the borrower would pay – at least initially – would be 5.5 percent. The rate will change over time as the index and loan terms change, per your loan agreement. If you are considering an ARM, ask your broker or lender which index will be used, how often it changes, how it has fluctuated in the past and where it is published.
Fixed-Rate Mortgages
Fixed-rate mortgages, those that are for 15 or more years in length, are considered long-tem lending. Unlike adjustable rate mortgages, fixed rate mortgages are not tied to an index. For the most part long-term mortgage rates have followed the yield on the ten-year Treasury bill, which tends to change with economic conditions.
Whatever your choice in a current or future mortgage, be sure to understand the terms and indices. Have your mortgage broker or lender walk you through relative advantages and disadvantages so you can weigh the options and make a wise, informed choice based on your individual circumstances.
Pamela Lamarre and Tracy Dearman are business partners and head California State Funding Group and HSM realty finance management, respectively. For a free consultation, CMA or more information about the mortgage market, email Lamarre at plamarre@sbcglobal.net or Dearman at tdearman@hsmsf.com. For additional information, visit www.hsmsf.com.
