Whether Online or in Person, Smart ARM Shoppers Run the Numbers

Q: I am in the market for a mortgage, and I found an adjustable-rate loan at less than 5 percent online. The monthly payment is affordable, and I expect that my income will grow over the next few years. However, I am leery about using the Internet and want to know what I should be concerned about.

A: You are wise to be concerned. The Internet is a great tool, but is still best to work with a real live person. Many of the Internet mortgage loan companies do not provide the personal interaction that is so important when you are making what may be the largest investment of your life.

There are many loans on the market today. The most common type is a fixed-rate mortgage. Here, your interest rate and monthly mortgage payments remain the same for the length of the loan. At the end of the loan period, the debt is paid off.

Most fixed-rate loans are for 30 years, but some go to 40 years. There are also 15-year fixed-rate loans, but I caution readers about them because of the financial strain they can create if you have trouble making the higher monthly payment. Besides, you can shorten the period of a 30-year loan simply by making extra payments.

The type of mortgage you are considering, an adjustable-rate loan, is also common. With this type of loan, also called an ARM, your monthly payments are fixed at a low rate for an initial period, which could be six months, one year, three years, five years or longer. However, at the end of this period, your rate will increase, depending on the terms and conditions of your loan.

ARMs began to show up in the early 1980s, when lenders became concerned that homeowners were paying off their old mortgages at 8 percent, 9 percent or 10 percent, while the cost of borrowing that money was more than 15 percent. Lenders then created a new range of options: The shorter the term of the loan, the lower the interest rate would be.

Most adjustable-rate mortgages are guaranteed to stay on the books for 30 years, but the interest rate is adjusted periodically. Prospective home buyers must carefully inquire about all of the terms and conditions before they commit themselves to any kind of mortgage. They must also insist on a written statement from their prospective lender.

Before you take out such a loan, here is what you should do:

Determine the initial interest rate. This is the rate you will pay during the initial period, usually one, three, five or seven years.

Find out how many points the lender will charge. Each point equals 1 percent of the loan. If you get a one-year adjustable-rate loan at 4.875 percent with two points, a loan of $275,000 will require you to pay $5,500 in points upfront at closing.

Paying points lowers your monthly payment: Usually, each point will reduce your rate by one-eighth of a percentage point. You might be able to persuade your seller to pay a point or two to reduce your rate and then deduct even those seller-paid points on your income tax return.

Ask if the ARM is based on a negative-amortization schedule. Most ARMs are not, but I have seen some loans with this factor built in. Negative amortization means that although you may be paying a lower interest rate, perhaps 5 percent for the first few years, the interest still is being charged to your loan at a higher rate -- for example 6.5 percent.

If this is the case, the extra interest (the difference between what you are paying and you are being charged) is added to your mortgage balance. I cannot recommend negative-amortization mortgages under any circumstances.

Determine what the rate adjustment will be. Find out if there is a cap on the periodic increases and what index the lender uses as a base for calculating changes in the rate. Generally, lenders look at the weekly average yield on Treasury bills, which is published by the Federal Reserve Board and printed in the financial pages of this newspaper.

Other lenders use an index known as LIBOR (London interbank offered rate). Ask your lender to provide you with historical data comparing these indexes. Adjustments are often capped, with rate ceilings for each year as well as for the life of the loan.

Make sure that your loan is based on a 30-year amortization schedule. You want written assurances that so long as you are current in your monthly mortgage payments, your loan will continue for a 30-year period. Some lenders have created adjustable-rate mortgages that balloon at the end of a set period -- for example, 10 years. This means that while the lender may renew your loan, it reserves the right to call the loan due at the end of the 10th year, depending on many circumstances, all of which must be outlined in writing before you commit yourself.

Anyone with an ARM is advised to carefully review the original loan documents to determine whether the lender has properly and correctly assessed the new adjustable rate, when the adjustment comes due. Lenders do make mistakes.

ARMs can be beneficial for many home buyers, but as the old saying goes, "You get what you pay for." You must do your homework -- and run the numbers -- before you sign up with any mortgage lender.

Benny L. Kass is a Washington lawyer. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, 1050 17th St. NW, Suite 1100, Washington, D.C. 20036. Readers may also send questions to him at that address or contact him through his Web site, http://www.kmklawyers.com.