Q. We are shopping around for a mortgage for our first home and are very confused about the many loans that currently seem to be available.
The adjustable-rate mortgage is of interest to us, but we do not really understand how that works. What exactly is an ARM, and do you have any comments on whether we should use this form of loan?
A. Every day, the creative-mortgage-financing industry comes up with a new kind of mortgage -- or at least a new twist on the old-fashioned ones. Interestingly enough, many of these mortgages have acronyms, and thus today you can find such mortgages as SAMs (Shared Appreciated Mortgages), GEMs (Growing Equity Mortgages), RAMs (Reverse Annuity Mortgages) and, of course, ARMs (Adjustable-Rate Mortgages).
The quantity of the mortgages now available makes it quite difficult for anyone -- whether a first-time buyer or an experienced speculator -- to determine exactly which is best.
Let's look at the adjustable-rate mortgage. This concept came about during the early 1980s, when lenders were burned because homeowners were repaying their loans at 8, 9 or 10 percent, while the cost of borrowing that money was then over 15 percent.
Lenders made a basic decision three or four years ago. The shorter the term of the loan, the lower the interest rate would be.
Thus, today you can still obtain a fixed-rate, 30-year mortgage, meaning that you will be guaranteed that, so long as you hold on to your loan, the mortgage payment will be the same every month. But the fixed-rate, 30-year mortgage -- even as low as it is now -- still carries about the highest interest rate going.
The adjustable-rate mortgage is guaranteed to stay on the books for 30 years, but the interest rate is adjusted periodically. There also are variations on the adjustable-rate mortgage theme. If the rate is adjusted every five years, for example, the initial rate will be lower than for a fixed-rate, 30-year mortgage, but higher than an adjustable rate that changes every year.
Today, the most common ARM is a one-year or three-year adjustable. But even here, consumers should shop around for the best deal.
Here's what you should look for.
First and foremost, what is the initial interest rate? This rate is defined as the interest rate on which your loan will be based for the adjustment period -- whether that is one or three years. Also, how many points is the lender charging for this loan?
Second, is the ARM based on a negative amortization schedule? Athough my experience is that most ARMs currently are not on such a negative basis, some still have the negative factor built in. This means that, although you may be paying a lower interest rate for the first year -- let's say 9 or 10 percent -- the interest still is being charged on your loan at a higher rate, for example 11 or 12 percent. If this is the case, the extra interest (the difference between what you actually are paying and what is being charged you) is added to your mortgage balance. Under no circumstances can I recommend the negative amortization kind of mortgage.
Next, determine what the yearly rate adjustment will be. Is there a cap on the yearly increases, and on what index does your lender base the adjustable rate?
Generally, lenders look at the weekly average yield on Treasury bills, which is published periodically by the Federal Reserve Board. However, the lender then adds to that index a rate adjustment (called a margin), and if this rate adjustment is over the old rate, then your interest will be adjusted accordingly for the next year. This is confusing, but let's look at an example:
The current Treasury bill index for one year is about 7.6 percent. If the rate adjustment offered by the lender (the index or margin) is 3 points, and even if the Treasury bill index stays at 7.6 percent next year, your new payments for the next year could be increased to 10.6 percent (7.6 plus 3).
However, if there is an annual rate cap, you will not (and cannot) be charged more than that cap. Thus, if your loan is $100,000 at an initial rate of 9 percent, and if there is a 2 percentage point cap on yearly adjustments, even if the index increases substantially, your new interest rate can only increase the first year to 11 percent (or 9 plus 2).
Yet another point to consider is whether there is a ceiling on the overall amount that your loan rate can increase. Most mortgage lenders realize that any ARM without such a ceiling is a potential disaster for consumers. If you start with a 9 percent loan, and there is a 2 percentage point cap on the yearly increases, it is conceivable that at the end of the fifth year, you could be facing a mortgage rate of 19 percent.
Thus, most lenders are now putting an overall ceiling on the amount that your interest rate can rise. And usually it is not more than 5 points maximum. Thus, if your initial rate is 9 percent, the most you can ever pay under the worst circumstances would be 14 percent. Make sure that you fully understand what the ceilings are and get them in writing before you commit yourself to an ARM.
Finally, some mortgage lenders are offering the option of converting the adjustable-rate mortgage into a fixed mortgage in later years.