Coping With Lenders’ Call to ARMs

QUESTION: I am buying a home for the first time in 25 years. I was prepared for the high prices but I hadn’t realized that most of the loans being offered these days are variable-rate ones. Frankly, they make me nervous and there are so many choices I have to make before I get one. Can you give me a list of some of the questions I should ask the lender and explain some of the terms, such as negative amortization?--D. P.

ANSWER: Shopping for a mortgage has, as you suggest, become more akin to buying a car: the options are dizzying. Add to that the fact that this is the most important financial decision many consumers have to make in their lifetimes, and it’s no wonder that mortgage shopping is a frightening and frustrating ordeal for many people.

With an adjustable-rate mortgage, the size of your future monthly payment is uncertain. As interest rates vary, so to a certain degree will that payment. In exchange for that uncertainty, your initial interest rate will be lower than the rate you would get on a fixed-rate mortgage.

Additionally, you benefit if interest rates decline, something consumers locked into a fixed-rate mortgage can’t take advantage of.

To compare adjustable-rate mortgages, or ARMs as they’re known in the lending business, you need to know about such things as caps, negative amortization, indexes, margins, discounts and convertibility.

But more important, you need to ask two questions: How much can you afford to pay now and in the future? And what is the maximum monthly payment you would ever be expected to make?

Make sure the lenders whose loans you are considering answer your second question. The other questions, while important, are all secondary to it.

Lenders say the single question they hear more than any other when it comes to adjustable-rate mortgages is whether there will be negative amortization. So, let’s begin there.

Negative amortization occurs when the monthly payments aren’t large enough to cover the interest on your loan and, at the same time, reduce the principal on your mortgage. The interest cost that isn’t covered is added to the unpaid balance of your mortgage.

In other words, you could owe more even after making several payments than you did when you took out the loan. This can happen when interest rates rise more sharply than the terms of the loan allow the monthly payment to increase.

When that occurs, lenders don’t swallow the interest cost not covered by the monthly payment. They add it to the unpaid balance of your loan and eventually you will have to repay it.

That worries a lot of consumers--older homeowners particularly. If it is a major concern to you, tell your lender. You can find a mortgage that does not have negative amortization, though it will cost you more in fees or a higher starting interest rate. Other mortgages contain a cap on negative amortization. Typically, these ceilings limit the total amount you would ever owe to 125% of the original loan. Another way to limit negative amortization is to voluntarily increase your monthly payment. But with today’s high housing costs, that is much more unpalatable to many home buyers than negative amortization is.

Here is a rundown of other points your lender should cover:

- How frequently will the interest rate and the monthly payment change?

- Which interest rate will your mortgage rate be tied to and how much have these rates fluctuated in recent years?

- How much will the lender add to those market interest rates to cover his own costs? (This is called the margin).

- Has your initial rate been discounted? And if so, how much will your rate rise once the discount period ends?

- Is there a limit on the amount your monthly payment can increase at any one time?

- Is there another limit on the amount your interest rate can increase over the life of your loan?

- If you ever decide to convert the loan to a fixed-rate mortgage or if you pay off the loan earlier than scheduled, will you be charged a prepayment penalty? If so, how much?

- Can the mortgage be assumed by the buyer of your home in the event you sell it before the loan is paid off?

- Are there fees and charges--these are called the points--payable in advance?

To give yourself some protection against wide fluctuations in interest rates, it is usually wise to get a mortgage with some guaranteed caps--either limiting how much your monthly payment can increase or limiting the interest-rate increase over the life of the loan, or both.

It isn’t unusual, for example, to find an adjustable-rate mortgage that limits increases in your interest rate to 5 percentage points over the life of the loan and prohibits your monthly payment from rising more than 7.5% in any one year.

To help consumers better understand adjustable-rate mortgages, the Federal Reserve Board and the Federal Home Loan Bank Board have prepared a booklet that spells out the complexities of these mortgages.

The free booklet, Consumer Handbook on Adjustable-Rate Mortgages, is available at most banks and savings and loan associations.

Q: My husband and I own a small farm, which we manage ourselves, except at harvest time, when we hire some extra help to get out the crops. We have never bothered to withhold Social Security from the hired hands’ pay. But another farmer down the road says he always does. What’s the rule?--I. M.

A: If you pay a worker $150 or more during the year, you are supposed to withhold Social Security taxes from his pay and pay the employer’s portion of those taxes.

The same ruling applies if you hire a farm worker for 20 or more days a year, regardless of the amount he or she receives.

Debra Whitefield cannot answer mail individually but will respond in this column to financial questions of general interest. Do not telephone. Write to Money Talk, Business section, The Times, Times Mirror Square, Los Angeles 90053.