How to select adjustable-rate home mortgage

STARTING OUT

May 01, 1994|By Dian Hymer

How do I select an adjustable-rate mortgage?

An adjustable-rate mortgage (ARM) is a home loan with an interest rate that fluctuates during the term of the loan. ARMs usually start with an interest rate that's about 2 to 2.5 percent below fixed-rate loans.

ARMs are tied to an index, which is a measure of the lender's cost of borrowing money. The index is used as a basis for calculating the interest rate on an ARM. As the index rises and falls, so will the interest rate on the ARM.

The longer the term of the index, the more the borrower is protected from short-term erratic interest rate fluctuations. For example an ARM with a six-month T-bill index will be more volatile than one with a 1-year index.

Many ARM lenders offer initial interest rates, called "teaser" or discounted rates, which are below the real or "fully-indexed" rate. The "fully-indexed" rate would apply after any discount or teaser rate ends. The "fully-indexed" rate is calculated by adding a margin, which is the lender's profit, to the index. Margins varies with ARM programs, but they are usually in the 2 to 3 percent range.

Whether or not a teaser rate is a good deal depends on the other terms of the loan. Find out how long the teaser rate will be in effect and what the interest rate will be after the first adjustment. Also, check the amount of the loan origination fees charged -- called "points." (One point is equal to one percent of the loan amount). The number of points vary with the lender who may charge higher points to offset a low teaser rate.

Some ARMs permit only one interest rate adjustment a year, others allow biannual or monthly adjustments. Some ARMs have an annual rate adjustment limit, called a "cap," of no more than 2 percent a year. Maximum life-time interest rate caps vary, but expect about 6 percent.

FIRST-TIME TIP: Determining which ARM is right for you will depend in part on how long you plan to stay in the house. A low initial interest rate and upfront fees will save you money if you plan to move again soon. The margin and lifetime cap will be less important because you won't be living with the loan for very long. If you plan to be in the home indefinitely, a lower margin is usually better than a lower starting interest rate. That's because the margin remains constant during the 15- or 30-year loan term and the initial discounted rate is temporary. A lower lifetime cap will be important because if interest rates were to rise and you were in your home long enough, this would hold down the long-term cost of owning your house.

An ARM that adjusts only once a year, but has a higher initial rate, may cost you less than one that adjusts twice a year but has a lower start rate. ARMs that adjust only once a year also have the benefit of enabling you to prepare for monthly payment adjustments. Six-month adjustments can be harder to handle.

Dian Hymer's column is syndicated through Inman News Features. Send questions and comments care of Inman News Features, 5335 College Avenue, No. 25, Oakland, Calif., 94618.

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