Q. We have a dilemma. We have just signed a contract to buy our first house, and it looks as if we have waited too long. Interest rates for fixed 30-year mortgages are now much higher than a few months ago. A mortgage lender has advised us to get an adjustable-rate mortgage (ARM). We like the lower interest rate but do not understand how it works. What exactly is an ARM? Is a fixed-rate mortgage more favorable than an ARM?
A. The Federal Housing Finance Board recently reported that 30 percent of the conventional mortgages that closed during August 1999 had adjustable interest rates. This was an increase from 25 percent in July, and a considerable rise from the record low of 8 percent in October 1998.
Thus, it appears many homebuyers are having the same dilemma. To compare an ARM with a fixed-interest-rate mortgage, you need to obtain all of the information about these two types of loans, and then "do the numbers."
If you plan to stay in the house for a period of time, you should look carefully at the various adjustable rates on the market. The spread between the fixed 30 and the one-year adjustable appears significant enough to give the latter serious consideration. On the other hand, if you are concerned that your rate (and your monthly mortgage payment) will be increasing on a yearly basis, you could also look at the 7-23 ARM.
Lenders are creative. When interest rates skyrocketed in the early 1980s, the mortgage financing industry began developing new and imaginative loans to meet consumer needs. Many of these mortgages have acronyms, and over the years we began to see such mortgages as GEMs (Growing Equity Mortgages), RAMs (Reverse Annuity Mortgages), SAMs (Shared Appreciation Mortgages) and of course ARMs (Adjustable Rate Mortgages).
Exactly what is an adjustable-rate mortgage?
This was created in the early 1980s when lenders became concerned that homeowners were holding mortgages at 8 percent, 9 percent or 10 percent, while the cost of borrowing money was more than 15 percent.
Lenders then made an important economic decision. The shorter the term of the loan, the lower the interest rate would be. Which is why today's fixed-rate 30-year mortgage (meaning that the monthly payment remains the same every month), while still reasonably low, carries the highest interest rate.
Most adjustable-rate mortgages are "written" for 30 years, but the interest rate is adjusted periodically. There are many variations on this adjustable-rate theme. There is a 7-23, where the rate is fixed for the first seven years and then adjusts annually for 23 more years. If the rate is adjusted after five or seven years, the initial rate will be lower than for a 30-year fixed-rate mortgage, but higher than an adjustable-rate mortgage that is adjusted every single year.
For example, one lender is offering a fixed 30-year loan at 7.875 percent with no points, a five-year ARM at 7.125 percent and no points, and a one-year ARM at 5.875 percent and no points.
Today, the most common ARMs are the one-year, the three-year and the 7-23. But even with these common ARMs, prospective home buyers must shop around. Consumers must also carefully inquire as to all of the terms and conditions before they commit themselves to any kind of mortgage financing. And in addition to asking questions, you must insist on getting a written statement from your prospective lender memorializing all that you have been told--and promised.
Here is what you should do:
* Determine the initial interest rate. This is the rate on which your loan will be based during the initial period, whether it is 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 at 5.875 percent and the lender is going to be charging you two points, a loan of $175,000 will require you to pay $3,500 in points, up front, when you go to settlement on your house.
Incidentally, keep in mind that by paying points you can effectively lower your monthly mortgage interest rate. A good ballpark is that each point will reduce your rate by one-eighth of a percent. The ideal solution is to persuade your seller to pay a point or two; you reduce your interest rate and can deduct the seller-paid points on your income tax return.
* Ask if the ARM is based on a negative-amortization schedule. Although my experience is that most ARMS currently are not amortized on such a negative basis, I still have seen some loans with a negative factor built in. This means that although you may be paying a lower interest rate, perhaps 5 percent or 6 percent for the first few years, the interest still is being charged to your loan at a higher rate--for example, 7.5 percent. If this is the case, the extra interest (the difference between what you are paying and what is being charged you) is added to your balance. I cannot recommend the negative-amortization mortgage under any circumstances.
* Determine what the rate adjustment will be. Find out if there is a "cap" on the periodic increases and determine which index the lender uses as a base for calculating changes in the adjustable 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. Some lenders also use the Eleventh District Federal Home Loan Bank Cost of Funds Index, while others use an index known as LIBOR (London Interbank Offered Rate). Ask your lender to provide you with historical data comparing these various indexes.
The lender then adds to that index number a rate adjustment called a "margin." If the adjusted rate is higher than the old one when your adjustment period comes due, your interest will be modified accordingly for the next set of payments.
For example, the current Treasury bill index for one year is 5.25 percent. The rate adjustment offered by the lender (the margin) is 2.75. Even if the Treasury bill index stays the same next year, if you have a one-year ARM and your current rate is 5.875 percent, your new payment for the next year could be increased to 8 percent (5.25 plus 2.75).
However, if there is an annual rate cap, all yearly adjustments on your mortgage payments cannot exceed that cap. Thus, if the initial rate of your loan was 5.875 percent and if there is a 2 percent yearly cap on adjustments, even if the index increases substantially, your new interest rate can only rise the first year to 7.875 percent (5.875 plus 2). Clearly, you should insist on having your loan documents include this yearly cap.
Another point to consider is whether there is a ceiling on the overall amount that your rate can increase. Lenders realize that an ARM without such a ceiling is a potential disaster for consumers--and potential bankruptcy and foreclosure problems for lenders. If you start with a 5.875 percent loan, for example, and there is a two-point cap in the annual increases, it is conceivable that at the end of the fifth year you would be facing a mortgage rate of 15.875 percent.
Most lenders, therefore, establish an overall ceiling on the amount that your interest rate can rise. It is usually limited to five or six percentage points. Thus, if your initial interest rate is 5.875 percent, the most you will ever pay--in the worst circumstances--would be 11.875 percent. However, you must make sure that you fully understand what these ceilings are, and get them in writing, before you commit yourself to an ARM or to a particular lender. You should also confirm that these ceilings are spelled out in the promissory note you will sign when you go to settlement.
You should also make sure that your loan is, in fact, based on a 30-year amortization schedule. You also 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 particular period of time--for example, 10 years. This means that while the lender may renew your loan, it reserves the right to call it due at the end of the 10th year, depending on many circumstances, all of which must be outlined in writing to you before you commit yourself to that particular kind of loan.
There are also serious problems with interpreting how the rate adjustments work after you get the loan. Anyone with an ARM is advised to carefully review their original loan documents, to determine whether the lender has properly and correctly assessed the new adjustable rate, when the adjustment period comes due.
A number of studies have concluded that lenders have made a number of mistakes. Ironically, not all of the mistakes were in the lender's favor.
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, Suite 1100, 1050 17th St. NW, Washington, D.C. 20036. Readers may also send questions to him at that address.