Even with caps, low starting rates, be wary of ARMs


February 03, 1991|By ELLEN JAMES MARTIN

The split-foyer that Ray Kreiner picked out in North Linthicum needs carpet and paint. But the audio engineer spent far less mental energy worrying about defects of the house than the adjustable-rate mortgage his agent was touting.

"You have a lot more to lose by the wrong loan than the wrong house. A house you can fix up but a loan you can't," Mr. Kreiner insists.

Despite heavy pressure from his agent, the 28-year-old Mr. Kreiner opted for a traditional fixed-rate loan rather than an ARM. A major reason was that he worried about the fine print contained in the ARM and how it could play out for him in real life.

"The bank doesn't create these sort of loans to lose money," he observes.

Mr. Kreiner is right to worry about the language buried in some ARM notes. Gone are the horrific adjustables of the early 1980s -- which started the borrower at an almost unbelievably low interest rate but then swept him into the stratosphere.

Yet even though most ARM rates are now all capped, potential land mines continue to await ARM borrowers.

"There are still some zingers out there you have to watch for," says Keith Gumbinger, an official of HSH Associates, the mortgage publishing firm in Butler, N.J.

Mortgage experts offer this advice on how to avoid curveballs:

* Watch out for confusing or hard-to-find ARM indexes.

An ARM index is used for mortgage interest adjustments. The current index value plus the margin (or lender's profit) are the basis on which the interest rate is calculated, although periodic and lifetime caps are also factored in.

A standard ARM index is something like the prime rate as published each Monday in the Wall Street Journal. Even with a standard index like that, it can be tough to track changes in your mortgage -- making sure the lender is on target. And errors in ARM computations are not unusual.

Now imagine how hard it is to follow your loan if you had this index: "The mean average of the Federal National Mortgage Association's fixed-rate 60-day mandatory price as published by Fannie Mae as of the last business day of each of the five calendar years preceding a change date."

Even mortgage professionals are stumped by that.

"We get hundreds of calls a month from people confused by their ARMs. Even simple ARMs are hard to understand. From the homeowner's point of view, the simpler the better," says David Ginsburg, president of Loantech Inc. of Gaithersburg, a mortgage consulting company.

* Watch out for a "moving average" index.

Your ARM may be pegged to a relatively common index, such as the three-month Treasury Bill rate. But then the lender adds an unusual twist. Your loan will adjust to an average of the rate for the 13 weeks prior to your change date.

That means you need to locate 13 figures plus do some arithmetic to figure out how your payments will change.

Unless you're planning to get a doctorate in mortgage science, you won't want an ARM with a moving average index.

* Look out for unusually high interest rate caps.

The typical ARM interest rate adjusts each year and, given a "periodic cap," typically can go up no more than 2 percentage points per year, according to Mr. Gumbinger. By the same token, the lifetime cap on the typical ARM is 6 percentage points, Mr. Gumbinger says.

Still, there's no law against a lender demanding higher caps. And some ARM lenders are demanding an annual cap as high as 2 1/2 percentage points and a lifetime cap above 7 percentage points, the HSHofficial has noticed.

* Beware of an ARM bearing an unusually high margin.

Assuming your loan is pegged to a standard index, you should be hit with a margin of no more than 3 percentage points above the index, according to Mr. Gumbinger of HSH Associates.

Still, a rare lender will impose an unusually stiff margin. Mr. Gumbinger says he has seen margins written into mortgage contracts that allow the lender to charge up to 5 1/2 percentage points above the current index value.

* Don't be fooled into thinking an ARM "convertibility clause" is necessarily a good thing.

Many homebuyers imagine they're getting the best of both worlds when they take an ARM with a low introductory rate and the promise of converting to a traditional fixed-rate loan if the ARM goes too high.

Yes, the lender will let you convert under this scenario. But look for language in your loan contract that would cause you to bear a particularly heavy margin if you convert. All this means that your new fixed-rate loan could be substantially above market and not such a great deal after all.

* Be careful about the fine print on a delayed-first-adjustment ARM.

It may sound like a great idea to take an ARM that promises no adjustment for three to seven years. But, of course, you're going to pay for the freedom from adjustments for so long a period.

One way you may be paying is in the initial interest rate pricing on the loan. Probably it will carry a rate that's a half or full percentage point above a more conventional ARM.

The other way you may pay is through "negative amortization." This happens when your current payments are kept artificially low at the beginning and some of the interest charges have been postponed. Then the unpaid interest is tacked onto the principal and you wind up owing more principal than you did at the outset.

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