A Call to ARMs: Give Them Close Examination

QUESTION: We are shopping around for a mortgage for our first home. We believe that now is the time to get into the market, because rates appear to be low and it’s a buyer’s market. We are interested in an adjustable rate mortgage but do not understand how it works. What exactly is an ARM and is this something we should consider

ANSWER: Since the early 1980s, when mortgage interest rates skyrocketed, the mortgage financing industry has developed new types of loans to meet different borrowers’ needs.

These have included mortgages such as GEMs (growing equity mortgages) RAMs (reverse annuity mortgages), SAMs (shared appreciation mortgages) and of course ARMs (adjustable rate mortgages).

The ARM was created in the early 1980s when lenders were affected financially because homeowners were repaying their loans at 8%, 9% or 10%, while the lender’s cost for money was more than 15%.

Lenders made a basic decision several years ago that 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 your monthly payment (principal and interest) is guaranteed to be the same each month. But the fixed rate, 30-year mortgage, although quite low today, still carries about the highest interest rate going.

Most ARMs are guaranteed to stay on the books 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 thereafter for 23 more years. If the rate is adjusted at five or seven, 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 year.

Today, the most common ARMs are the one-year adjustable, the three-year adjustable and the 7-23. But even with these common ARMs, consumers must shop around for the best deal. Consumers must also carefully inquire as to all of the terms and conditions before they commit themselves to any kind of mortgage financing.

Here is what you should do:

* Determine the initial interest rate. It is defined as 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 is charging. Each point equals 1% of the loan. Thus, if you are obtaining a one-year adjustable rate at 5%, and the lender is going to be charging you 3 1/4 points, a loan of $150,000 will require you to pay $4,875 in points--up front--when you close escrow on your house.

* Ask if the ARM is based on a “negative amortization” schedule. This means that although you may be paying a lower interest rate, perhaps 5% to 7% for the first few years, the interest still is being charged on your loan at a higher rate--for example 8% or 9%. If this is the case, the extra interest, which is the difference between what you are paying and what is being charged you, is added to your mortgage balance. I do not 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 what index the lender uses as a base for calculating changes in the adjustable rate.

Many lenders in the West use the 11th District Federal Home Loan Bank Cost of Funds Index. Others use the weekly average yield on Treasury bills.

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 4.34%. The rate adjustment offered by the lender (the margin) is 3 points. Even if the Treasury bill index stays at 4.34% next year, if you have a one-year ARM, and your current rate is 5%, your new payment for the next year could be increased to 7.34%. This will no doubt be rounded up to 7.5%.

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 5%, and if there is a 2% yearly cap on adjustments, even if the index increases substantially, your new interest rate can only rise the first year to 7% (or 5 plus 2).

Another point to consider is whether there is a ceiling on the overall amount that your rate can increase. If you start with a 5% loan, for example, and there is 2% 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%.

Most lenders, therefore, put an overall ceiling on the amount that your interest rate can rise. And it is usually limited to six percentage points. Thus, if your initial interest rate is 5%, the most you will ever pay would be 11%. However, 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.

This analysis is equally valid for other kinds of ARMs, whether the three year, the 5-25, or the 7-23.

You should also make sure that your loan is, in fact, based on a 30-year amortization schedule, and of equal importance, whether your loan continues for a 30-year period. Some lenders have created adjustable rate mortgages that have a balloon payment due at the end of a particular period of time--for example, 10 years. This means that while the lender will probably renew the loan, it reserves the right to call it due at the end of the 10th year, depending on many circumstances, all of which must.

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 the original loan documents.