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Annual Percentage Rate (APR)
In comparing any type of loan, whether it be a fixed rate loan to a fixed rate loan, adjustable rate loan to adjustable rate loan or fixed rate loan to adjustable rate loan, there is one way that can be used to compare apples to apples and even apples to oranges.
APRs are designed to do just that. APRs are a way to calculate the annual cost of loans, taking into consideration loan origination fees (points) and the other costs associated with securing a loan. The additional costs include appraisal and credit report fees as well as processing and document fees.
One confusing aspect of APRs is that the APR on 15 year loans will carry a higher relative rate due to the fact that the points are amortized over the 15 year term rather than the 30 year term. When a Regulation Z (Reg Z, the mortgage companies disclosure of cost for the loan) is prepared for a buyer/borrower the prepaid interest is also included in the APR calculation. For our illustrations we will use only the points, appraisal, credit report, processing and document fees.
As a means of protecting consumers from companies who did not disclose the fees associated with a particularly low start rate on an adjustable rate loan or below market rate on a fixed rate loan, APRs give consumers a way to check the true cost of a loan.
One common situation that occurs when a borrower receives a Reg Z, and a copy of their note, is the column that indicates the amount financed is less than the loan amount the borrower is actually financing. It is here that many borrowers leap before they look and call to find out why they are only receiving a $146,925 loan when they applied for a $150,000 loan. It is here that APRs enter the picture.
Let's look at how APRs are calculated. For our illustration we will assume a 8.50% fixed rate interest. For a 30 year loan the monthly payments for a $150,000 loan are $1,153.37.
In order to calculate the APR for this loan we subtract $2,250.00 (1.50 points), $275.00 appraisal fee, $50.00 credit report fee, $500.00 processing, document and other fees. ($150,000 - $3,0750 = $146,925). The $146,925 is then used as the present value/loan amount to determine the true cost of this loan. By solving for the new interest rate for a $146,925 loan with the same payment of $1,153.37, the APR is calculated as 8.73%.
How does this compare to a 30 year fixed rate loan with a 8.00% interest rate and 3.50 points? The monthly payments for this loan is $1,100.65.
In order to calculate the APR for this loan we subtract $5,255.00 (3.50 points), $275.00 appraisal fee, $50.00 credit report fee, $500.00 processing, document and other fees. ($150,000 - $6,075 = $143,925). The $143,925 is then used as the present value/loan amount to determine the true cost of this loan. By solving for the new interest rate for a $143,925 loan with the payment of $1,100.65 the APR is calculated as 8.44%.

Adjustable Rate Mortgages (ARM)
These loans generally begin with an interest rate that is 2-3 percent below a comparable fixed rate mortgage, and could allow you to buy a more expensive home.
However, the interest rate changes at specified intervals (for example, every year) depending on changing market conditions; if interest rates go up, your monthly mortgage payment will go up, too. However, if rates go down, your mortgage payment will drop also.
There are also mortgages that combine aspects of fixed and adjustable rate mortgages - starting at a low fixed-rate for seven to ten years, for example, then adjusting to market conditions. Ask your mortgage professional about these and other special kinds of mortgages that fit your specific financial situation

Introductory Rate ARM's
Most adjustable rate loans (ARMs) have a low introductory rate or start rate, some times as much as 5.0% below the current market rate of a fixed loan. This start rate is usually good from 1 month to as long as 10 years. As a rule the lower the start rate the shorter the time before the loan makes its first adjustment.
Index - The index of an ARM is the financial instrument that the loan is "tied" to, or adjusted to. The most common indices, or, indexes are the 1-Year Treasury Security, LIBOR (London Interbank Offered Rate), Prime, 6-Month Certificate of Deposit (CD) and the 11th District Cost of Funds (COFI). Each of these indices move up or down based on conditions of the financial markets.
Margin - The margin is one of the most important aspects of ARMs because it is added to the index to determine the interest rate that you pay. The margin added to the index is known as the fully indexed rate. As an example if the current index value is 5.50% and your loan has a margin of 2.5%, your fully indexed rate is 8.00%. Margins on loans range from 1.75% to 3.5% depending on the index and the amount financed in relation to the property value.
Interim Caps - All adjustable rate loans carry interim caps. Many ARMs have interest rate caps of six-months or a year. There are loans that have interest rate caps of three years. Interest rate caps are beneficial in rising interest rate markets, but can also keep your interest rate higher than the fully indexed rate if rates are falling rapidly.
Payment Caps - Some loans have payment caps instead of interest rate caps. These loans reduce payment shock in a rising interest rate market, but can also lead to deferred interest or "negative amortization". These loans generally cap your annual payment increases to 7.5% of the previous payment.
Lifetime Caps - Almost all ARMs have a maximum interest rate or lifetime interest rate cap. The lifetime cap varies from company to company and loan to loan. Loans with low lifetime caps usually have higher margins, and the reverse is also true. Those loans that carry low margins often have higher lifetime caps.

Interest Rate Buydowns
The most common buydown is the 2-1 buydown. In the past, for a buyer to secure a 2-1 buydown they would pay 3 points above current market points in order to pay a below market interest rate during the first two years of the loan. At the end of the two years they would then pay the old market rate for the remaining term.
As an example, if the current market rate for a conforming fixed rate loan is 8.5% at a cost of 1.5 points, the buydown gives the borrower a first year rate of 6.50%, a second year rate of 7.50% and a third through 30th year rate of 8.50% and the cost would be 4.5 points. Buydown costs were usually paid for by a transferring company because of the high points associated with them.
In today's market, mortgage companies have designed variations of the old buydowns rather than charge higher points to the buyer in the beginning they increase the note rate to cover their yields in the later years.
As an example, if the current rate for a conforming fixed rate loan is 8.50% at a cost of 1.5 points, the buydown would give the buyer a first year rate of 7.25%, a second year rate of 8.25% and a third through 30th year rate of 9.25% , or a three-quarter point higher note rate than the current market and the cost would remain at 1.5 points.
Another common buydown is the 3-2-1 buydown which works much in the same ways as the 2-1 buydown, with the exception of the starting interest rate being 3% below the note rate. Another variation is the flex-fixed buydown programs that increase at six month interval rather than annual intervals.
As an example, for a flex-fixed jumbo buydown at a cost of 1.5 points, the first six months rate would be 7.50%, the second six months the rate would be 8.00%, the next six months rate would be 8.50%, the next six months rate would be 9.00%, the next six months the rate would be 9.50% and at the 37th month the rate would reach the note rate of 9.875% and would remain there for the remainder of the term. A comparable jumbo 30 year fixed at 1.5 points would be 8.875%.

Graduated Payment Mortgage (GPM)
The GPM is another alternative to the conventional adjustable rate mortgage, and is making a comeback as borrowers and mortgage companies seek alternatives to assist in qualifying for home financing
Unlike an ARM, GPMs have a fixed note rate and payment schedule. With a GPM the payments are usually fixed for one year at a time. Each year for five years the payments graduate at 7.5% - 12.5% of the previous years payment.
GPMs are available in 30 year and 15 year amortization, and for both conforming and jumbo loans. With the graduated payments and a fixed note rate, GPMs have scheduled negative amortization of approximately 10% - 12% of the loan amount depending on the note rate. The higher the note rate the larger degree of negative amortization. This compares to the possible negative amortization of a monthly adjusting ARM of 10% of the loan amount. Both loans give the consumer the ability to pay the additional principal and avoid the negative amortization. In contrast, the GPM has a fixed payment schedule so the additional principal payments reduce the term of the loan. The ARMs additional payments avoid the negative amortization and the payments decrease while the term of the loan remains constant.
The scheduled negative amortization on a GPM differs depending on the amortization schedule, the note rate and the payment increases of the loan. GPM loans with 7.5% annual payment increases offer the lowest qualifying rate but the largest amount of negative amortization.
On a loan of $150,000, with a 30 year amortization and a note rate of 10.50% with 12.5% annual payment increases, the negative amortization continues for 60 months. The qualifying rate is 5.75% and the negative amortization is 11.34% (approximately $17,010).
The note rate of a GPM is traditionally .5% to .75% higher than the note rate of a straight fixed rate mortgage. The higher note rate and scheduled negative amortization of the GPM makes the cost of the mortgage more expensive to the borrower in the long run. In addition, the borrowers monthly payment can increase by as much as 50% by the final payment adjustment.
The lower qualifying rate of the GPM can help borrowers maximize their purchasing power, and can be useful in a market with rapid appreciation. In markets where appreciation is moderate, and a borrower needs to move during the scheduled negative amortization period they could create an unpleasant situation.

London InterBank Offered Rate (LIBOR)
LIBOR is the rate on dollar-denominated deposits, also know as Eurodollars, traded between banks in London. The index is quoted for one month, three months, six months as well as one-year periods.
LIBOR is the base interest rate paid on deposits between banks in the Eurodollar market. A Eurodollar is a dollar deposited in a bank in a country where the currency is not the dollar. The Eurodollar market has been around for over 40 years and is a major component of the International financial market. London is the center of the Euromarket in terms of volume.
The LIBOR rate quoted in the Wall Street Journal is an average of rate quotes from five major banks. Bank of America, Barclays, Bank of Tokyo, Deutsche Bank and Swiss Bank.
The most common quote for mortgages is the 6-month quote. LIBOR's cost of money is a widely monitored international interest rate indicator. LIBOR is currently being used by both Fannie Mae and Freddie Mac as an index on the loans they purchase.
LIBOR is quoted daily in the Wall Street Journal's Money Rates and compares most closely to the 1-Year Treasury Security index.

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