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Friday, October 19, 2007

Exploding Arms - Variable Rate Loans

You may or may not have heard of this term in the news. It refers to an adjustable rate loan that is set to a fixed rate for a short period of time and tied to an index. When the fixed period ends, your loan converts to an adjustable loan that moves based on the index fluctuations. Your rate and payments can increase by a significant amount if the index has moved up. The current market is characterized by low fixed rate loans tied to indexes that have gone up by 2-5% points depending on when they were recorded. Rates were at historic lows but over the few 7 years these indexes have steadily increased. For example, the Prime Rate, usually used for equity lines, has climbed from a low of 4.0 in 2004 to 7.75 now. (It reached 8.25 in mid 2006).

Examples of Indexes used for Fixed adjustable:-Prime Rate-6 month LIBOR -Costs of Funds (COFI)-Costs of Savings (COSI)-Monthly Treasury (MTA)

If you purchased or refinanced in the past few years, you may have received an adjustable loan and may not even be aware of it. These loans are meant to be short term ways to lower payments, or for borrowers looking to sell some time in the near future. If you don’t plan on living in a home for many years this could be a great loan for you.

The problem arises when borrower have short term loans, and plan on staying in the home longer than the fixed period. In the current market borrowers have been financing purchases with 2 and 3 year fixed loans with indexes that have skyrocketed and are causing huge payment burdens on the uneducated borrower.

Examples of exploding arms include:
-2 year Fixed - fixed for 2 years then variable for 28 years (aka 2/28)
-3 year Fixed - fixed for 3 years then variable for 27 years (aka 3/27)
-5 year Fixed - fixed for 5 years then variable for 25 years (aka 5/25)
-7 year Fixed - fixed for 2 years then variable for 23 years (aka 7/23)
-10 year Fixed - fixed for 10 years then variable for 20 years (aka 10/20)

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