With mortgage interest rates moving up, we are looking carefully at an adjustable-rate mortgage. However, we really do not fully understand how it works, and would like your comments on this kind of mortgage.
Unfortunately, in the past few months, mortgage interest rates rose considerably.
Needless to say, many people are reluctant to lock themselves into a fixed 30-year rate at more than 11 percent, and are trying to gamble -- take a little risk -- that interest rates will fall again in the next few years.
In the early 1980s, many homeowners were paying back mortage loans at 8, 9 or 10 percent, while the cost of borrowing that money was then more than 15 percent.
Lenders made a basic decision then that the shorter the term of the loan, the lower the interest rate would be. Thus, the origin of the adjustable mortgage -- called an ARM.
Today you can still obtain a fixed-rate 30-year mortgage, meaning you will be guaranteed that your mortgage payment will be the same every month so long as you have the loan.
But the fixed-rate 30-year mortgage carries about the highest interest rate going today.
The adjustable-rate mortgage became popular a few years ago. This kind of loan is guaranteed to stay on the books for 30 years, but the interest rate will be periodically adjusted.
There also are variations on the adjustable mortgage theme. If the rate is adjusted every five years, for example, the initial rate will be lower than for fixed-rate 30-year mortgages, but higher than for an adjustable rate that changes every year.
Today, the most common ARMs are adjusted every year, every three years or every five years.
Consumers should shop for the best deal and here's what you should look for.
First and foremost, what is the initial interest rate? This is defined as the interest rate on which your loan will be based for the first adjustable period, whether that is one year, three years or five. Also, how many points is the lender going to charge before approving this loan? Each point amounts to 1 percent of the loan amount.
Second, is the ARM based on a negative amortization schedule? Although most ARMs currently are not on such a negative basis, there are still some loans that have the negative factor built in.
This means that although you may be paying a low interest rate for the first year -- let's say 7 or 8 percent -- the interest still is being charged on your loan at a higher rate, perhaps 10 or 11 percent. If this is the case, the extra interest (the difference between what you were actually paying and what is being charged you) will be added to your mortgage balance.
Next, determine what the rate adjustment will be. Is there a cap on the increase, and on what index does your lender base the adjustable rate?
At the end of this year, a new law takes effect that requires a life cap on every ARM. Currently, although most lenders offer a cap, there is no legal requirement that one be available.
Generally, lenders look at the weeky average yield of one-year Treasury bills, which is published periodically by the Federal Reserve Board.
However, the lender adds to that index a rate adjustment (often called a margin) and if this rate adjustment is more or less than the old rate, then your interest will be adjusted accordingly in the next adjustment period.
This sounds confusing, but let's look at an example.
Let us assume the current Treasury bill index is 7.5 percent. If the rate adjustment (margin) offered by the lender is three points, even if the Treasury bill index stays at 7 1/2 percent next year, your new payment on a one-year adjustable for the next year could be increased to 10 1/2 percent.
However, if there is an annual interest cap, you will not be charged more than that cap. Thus, if your loan is $100,000 at an initial rate of 7.75 percent for 30 years, and there is a 2 percent point cap on yearly rate adjustments, if the index increases by 3 percent at the end of the first year, your new interest rate would only increase to 9.75 percent.
Another point to consider is whether there is an overall ceiling on the amount that your loan rate can increase.
Most mortgage lenders realize that the ARM without a ceiling is a potential disaster for consumers.
If you start with 7.75 percent, and there is a 2 percent point cap on the yearly increases, it is conceivable that, at the end of the fifth year, you will be facing a mortgage rate of 17.75 percent.
Thus, lenders now are putting an overall ceiling on the amount that your interest rate can go up. Usually, that cap is between 5 to 6 percentage points. Make sure you fully understand what the caps are, and make sure they're in writing before you commit yourself to take the ARM.
Finally, some mortgage lenders are offering the option to convert the adjustable rate mortage into a fixed-rate mortgage at a later date. If this option is available, obtain from the lender a clear understanding of how it works, when you can exercise this option, and what fee (if any) will be charged -- and when.
The adjustable-rate mortgage ofers flexiblity for many owners. If, for example, you will be keeping the house for only three or four years, it may make sense to use the lower ARM concept. However, you should receive a written explanation spelling out the terms and conditions of the ARM. Insist on receiving this material while you are shopping for a loan. You should also compare the spread (i.e., the difference between the ARM initial rate and the current fixed rates for 15- or 30-year loans). When fixed-rate loans are low, give serious thought as to the real desirability of an ARM. Benny L. Kass is a Washington attorney. 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, Suite 1100, 1060 17th St. NW, Washington, D.C. 20036. Readers also may send questions to him at that address.