Mortgage Basics

The term Alt-A refers to a loan which is issued to a borrower with less than the ideal characteristics.  Alt-A loans have more risk than prime conforming loans which are purchased by Freddie Mac/Fannie Mae but are less risky than sub-prime loans which are issued to the riskiest borrowers.  Alt-A loans will have higher interest rates than your typical A-paper loans due to the added risk profile of the borrower.  The added risk could come in the form of a higher debt to income ratio, high loan to value ratio, or even a credit rating which is less than excellent.  Most Alt-A borrowers have a credit score which is high enough to consider them a candidate for a conforming loan; however, the other factors we mentioned above are typically deficient, creating a less than ideal borrowing profile.

Alt-A loans have lower documentation requirements and do not need to verify the borrowers income.  This is prevalent in borrowers who have employment in industries which have heavy compensation in the form of tips or even those who work "under the table".  Many times, Alt-A borrowers do not have enough W2 income or personal assets, meaning that the bank will need to use it's judgement in issuing these loans on a case by case basis.

There are a few basic features of an adjustable rate mortage that you should be aware of in order to adequately evaluate the risk versus reward that is associated to an ARM.

Fixed Portion of ARM

Let's start with the initial rate that you receive on the mortgage.  The initial rate will remain in effect for a period of 1 month up to 15 years, depending on the type of loan you select.  Once that period is over, the mortgage will convert into a fully amortizing loan; the amortization schedule used to calculate your payments will be determined by your loan type.  Typically, your loan is based off a 30 year amortization scheudule and therefore, your loan will be amortized for a period equal to 30 - # of years with initial rate.  For example, if you had a 5 year ARM, your loan would start fully amortizing on a 25 year schedule after year 5.

It is important to note that your payment could drastically increase once the interest rate becomes adjustable.  The general rule of thumb is to look at the the spread between the initial rate and the APR on the mortgage.  If the difference between these two numbers is high, the lender is essentially lumping additional charges into the loan which will come into play once the initial rate period has expired.  Basically, if the spread is high, expect your monthly payment to increase once the initial rate period is over. 

Rate Adjustments

Every ARM has an adjustment period which determines the dates and frequency at which interest rates can change.  For example, a 5/1 ARM is designed to adjust every year after the 5 year initial period.

Index & Margin

Once the initial period of the ARM is over, the interest rate of the loan will adjust based on a general interest rate index which will have a margin added to it.  As this loan has now become a variable rate loan, banks use a published index such as LIBOR , Cost of Funds Index (COFI), or the US Constant Maturity Treasury (CMT) to benchmark the loan's interest rate with an interest rate that represents the current interest rate environment.  This index will be the base component of the rate that the borrower is charged.  Banks will add a margin, or extra basis points, to the index which reflects your credit worthiness and some backend bank fees.  Depending on the prevailing interest rates, your monthly mortgage payment may stay relatively close or may jump dramatically.

Interest Rate Caps

Interest rate caps are exactly what they sound like; they will limit the periodic rate increases on an adjustable rate mortage.  Caps will typically exists at a periodic level and at a macro level which limits the total lifetime increase.  For instance, assume you have a 5/1 ARM with a 3/2/5 structure.  The 3 stands for the maximum rate increase in the first year after the initial period, 2 represents the maximum rate increase per period and 5 represents the maximum cap over the lifetime of the loan.

<<Part 1- Adjustable Rate Mortgage Introduction                        Part 3 - Types of ARMs>>

Balloon Mortgage – Definition

A balloon mortgage is a loan type where the borrower makes a fixed monthly payment for a fixed amount of time ranging from 5 to 15 years, and then is required to payoff outstanding principal balance on the home with a lump sum payment.  A balloon mortage uses a 30 year amortization table; however, the interest rate will be lower with the balloon simply due to the fact that the lender is assuming less interest rate risk with a loan that spans 30 years.

Homeowners sometimes opt for this type of loan in anticipation of a large settlement or inheritance; however, those that do not can sometimes can enter into a risky situation.  If the loan does not get paid down, it will be refinanced with a new product and terms; however, a problem may arise in the future if the borrowers credit quality has dropped significantly or if home prices take a dive.  In the latter case, the borrower may be attempting to refinance the home with a LTV ratio of over 100%.  Rates may be extremely unfavorable in this situation and payments could drastically jump.

Balloon Mortgage Vs. ARM

A balloon mortgage is similar in theory to an adjustable rate mortgage; they both have a fixed rate period followed by an adjustment.  Assuming that the borrower refinances their mortgage, the balloon and ARM carry similar interest rate risks after the initial period.  While a balloon payment may be lower than a comparable termed ARM, the interest rate risk is large if interest rates rise dramatically.  ARMs have built in caps, or ceilings that limit how high interest rates move regardless of how high they actually are.  Conversely, balloon mortages will make the borrower refinance at the prevailing market rate, regardless of what it is.  When refinancing in a high rate enviroment, borrowers may no longer qualify for a loan if the payment jumps dramatically.  Additionally, there are costs associated with refinancing a home, the ARM will not incur this cost while the Balloon will.

In conclusion, be very careful and understand the risky nature of entering into a balloon mortgage.  In most cases, it is not advantageous for the borrower to do so primarily due to the risk that is associated to it once the borrower will need to refinance.  If you do not have the cash and you are not able to refinance, you will be forced to sell the house or foreclose on it.