Finding a Good Sliding-Rate Mortgage Loan

So you’ve found out that your dream house costs a touch more than you think you can afford. But your lender says you can probably qualify for the loan if you get an adjustable-rate mortgage.

Adjustable loans are often just the ticket for young home buyers who are reasonably certain that their income is climbing. Because of low “teaser” rates, adjustable loans often allow consumers to buy a somewhat bigger house.

On the other hand, adjustable loans are generally not a great option for those on a fixed income. Why? Once the teaser period is over, rates on these loans tend to rise. Unless your income is rising too, making the payments can become a strain.

Consumers need to be cautious when choosing an adjustable loan. There are far more variables than just the rate and up-front fees. Ignoring these variables can prove costly. Nevertheless, if you carefully examine the mortgage before you buy, you can usually avoid any unpleasant surprises.

Here’s what you should be looking for:

First, check the initial interest rate. Often, with an adjustable, this will be the so-called teaser rate--a short-term, rock-bottom price designed to get you in the door.

It is important to find out how long that teaser rate will be guaranteed. In some cases, the lender keeps the rate artificially low for a full year. In other cases, you get that low rate only for a few months.

Since you can’t predict interest rates, look at what the mortgage’s rate would be if it were “fully phased in.” In other words, assume that the teaser period is over and you are paying a set amount over an index. Then compare that rate to the going rate on fixed loans.

Then you need to know how much the rate can rise in each adjustment period. Most lenders will have adjustment caps that put a lid on how high your interest rate and payments can go. Typically, these caps amount to one or two percentage points per year.

In other words, if your initial rate was 7.5%, the rate couldn’t go above 8.5% in the first adjustment if you have a one-percentage-point cap. Many loans also have lifetime caps that guarantee that your loan rate will never rise more than five or six percentage points above the initial rate.

These rate caps are important to figuring out the potential cost of your loan.

Some lenders also offer payment caps. These keep your monthly mortgage payments steady, but they don’t save you any money. Payment caps just defer and finance the expenses. In the end, they’ll cost you money because you are paying interest on top of interest.

For example, let’s say you have a $1,500 monthly payment cap on a $160,000 mortgage. Interest rates rise to the point where your actual monthly payment would be $1,600. But because of the payment cap, the bank can’t charge you that extra $100. What do they do? They add it to the balance of your loan.

You now owe $160,100. The bulk of your mortgage payments, particularly in the early years, are interest costs. So you now owe interest on an extra $100, which, itself, was mostly interest. The technical term for this is “negative amortization.”

Also consider how frequently your loan will be adjusted. In some cases, the bank will change the rate only once or twice a year; in other cases, rates change monthly.

You should also examine the index that your loan is tied to. The most common indexes are those tied to Treasury bill rates or to 11th District cost of funds, an index that measures the cost of loan money for institutions in several Western states. Generally speaking, the 11th District cost of funds index is a little more stable. That’s good if you want to limit payment shock. But it’s bad when interest rates are falling, because your rate cuts will as slow as the hikes.

Lastly, you need to be aware of the loan fees, including points, appraisal fees, costs for credit reports and processing.

Often the points, which are usually prepaid interest, are factored into the cost of your loan. In other words, if you are getting an unusually low rate, you might also be paying high points and vice versa.

Just as rates vary from bank to bank, so do points and other up-front fees. Doing a little comparison shopping could save you hundreds of dollars.