YOUR MORTGAGE : Making Sense of Lenders’ Terms

QUESTION: We are shopping around for a mortgage for our first home, and are very confused about the many mortgages that currently are available. The adjustable-rate mortgage is of interest to us, but we do not understand how that works.

We have heard that there may be problems with this kind of loan. What exactly is an adjustable-rate mortgage, and do you have any advice on whether we should use this form of loan?

ANSWER: Every day, it seems that the creative mortgage financing industry comes up with a new kind of mortgage--or at least a new twist on the old ones. Many of the mortgages have acronyms, and thus you may see such mortgages as RAMs (reverse annuity mortgages), SAMs (shared appreciation mortgages), GEMs (growing equity mortgages), and, of course, ARMs (adjustable rate mortgages).

The larger number of mortgages currently available makes it quite difficult for anyone--be you a first-time buyer or an experienced investor--to determine exactly which mortgage is best.

The adjustable-rate mortgage was created in the early 1980s, when lenders were burned because homeowners were repaying their loans at 8%, 9% or 10%, while the cost of that money was then over 15%.

About eight or nine years ago, lenders made a basic decision. 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 the mortgage payment will be the same every month. But the fixed-rate 30-year mortgage--even though currently quite low--still carries about the highest interest rate going.

The adjustable-rate mortgage is also guaranteed to stay on the books for 30 years, but the interest rate is adjusted periodically. There are variations on the adjustable-rate theme. If the rate is adjusted every five years, for example, the initial rate will be lower than for a fixed 30-year mortgage, but higher than an adjustable-rate mortgage that adjusts every year.

Today, the most common ARMs are the one-year or three-year adjustable. But even here, consumers should shop around for the best deal.

Here is what you should look for:

First and foremost, what is the initial interest rate? This rate is defined as the rate on which your loan will be based in the adjustment period, whether that is one, three or five years.

Second, is the ARM based on a negative amortization schedule? Although my experience is that most ARMs currently are not amortized on a negative basis, some lenders are still using the negative factor.

This means that, although you may be paying a low interest rate for the first year--let’s say 7 1/2% or 8 1/2%--the interest is still being charged on your loan at a higher rate, for example 10% or 11%.

If this is the case, the extra interest payment (the difference between what you are paying and what is being charged you) is added to your mortgage balance. Under no circumstances can I recommend the negative amortization 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?

Many lenders look at the weekly average yield on one-year Treasury bills, which is published periodically by the Federal Reserve Board. Other lenders use the so-called “cost of funds” approach, while others are beginning to use the London Interbank Offered Rate (also called LIBOR). The question of which index is better for home buying consumers is hotly debated, and must be reserved for a subsequent column.

However, the lender then adds to that index a rate adjustment (called a margin), and if the adjusted rate is higher than the old one, your interest will be modified accordingly for the next year. This is confusing, but let us look at an example.

The current Treasury Bill Index for one year is about 7.8. If the rate adjustment offered by the lender (the index or margin) is 3 points, even if the index stays at 7.8% next year, your new payments for the next year could be increased to 10.8% (7.8 plus 3).

However, if there is an annual rate cap, you cannot be charged more than that cap. Thus, if your loan is $100,000 at an initial rate of 7.5%, and if there is a two-percentage point cap on yearly adjustments, even if the index increases substantially, your new interest rate can only rise the first year to 9.5% (or 7.5 plus 2% cap).

Another point to consider is whether there is a ceiling on the overall amount that your rate can increase. Lenders realize that the ARM without such a ceiling is a potential disaster for consumers. If you start with a 7.5% loan, and if there is a 2% 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 17.5%, if our economic picture becomes severe.

Thus, most lenders are now putting an overall ceiling on the amount that your interest rate can rise. And usually it is limited to between 5 and 6 percentage points. Thus, if your initial rate is 7.5%, the most you can ever pay wold be 13.5%.

Make sure that you understand what the ceilings are and get them in writing before you commit yourself to an adjustable-rate mortgage.

Many lenders are also offering the option of converting the adjustable-rate mortgage into a fixed-rate mortgage down the years. If this option is available, obtain a clear understanding of how it works, when you can exercise this option and what, if any, fee will be charged.

The adjustable-rate mortgage offers flexibility for many homeowners. However, as in today’s market conditions, where the spread between the initial ARM and a fixed-rate mortgage is relatively small, you have to give serious thought to whether you want the luxury of an initial low rate, with the potential drawback of that rate increasing in subsequent years.

Additionally, you also have to determine how long you believe you will be staying in your new property. If you will be keeping the house or the condominium for only three or four years, in my opinion it certainly makes sense to use the lower ARM concept.

Remember, you have the right to shop around for the best possible rate.