What Every Buyer Should Know About Adjustable-Rate Mortgages
When choosing an adjustable-rate mortgage, weigh the loan terms carefully. Here is a guide to the important terms of an ARM.
* Introductory rate: Most adjustable loans have a low starting rate, typically called an intro rate. A recent survey of lenders found introductory rates as low as 2.95%. However, you also need to know how long this bargain-basement rate will last. Sometimes it’s set for just three months. In other cases, you get the introductory rate for as long as a year.
* Index: After the introductory period, the cost of an ARM is based on an interest rate index. The most popular are the one-year Treasury index and the 11th District cost of funds index (COFI), which is based on borrowing costs for West Coast savings and loans. Some loans are also tied to the London Interbank Offered Rate or the banks’ prime rate. Generally speaking, indexes based on a lender’s cost of funds, such as COFI, move the slowest. The others move fairly quickly.
* Margin: To determine your interest rate, add the current index number to the “margin”--the amount above the index that you pay. For instance, if the margin on your loan is 2.5 percentage points and the index is 4%, you’ll pay 6.5%. Commonly, the margins on COFI loans range between 2.35 and 2.75 percentage points, while the margins on T-bill loans are somewhat higher--usually between 2.75 and 2.875 percentage points.
* Annual interest rate caps: Many ARMs offer annual interest rate caps of two percentage points. That’s the most your loan rate could rise in one year.
If your loan rate starts at 4%, for example, the rate couldn’t exceed 6% in year two, 8% in year three or 10% in year four--no matter what happened to interest rates during those years. Annual rate caps are an important fail-safe measure if you happen to secure an ARM when interest rates are rising rapidly.
* Lifetime rate caps: Almost all ARMs have lifetime interest rate caps that limit the topmost rate you could potentially pay on the loan. A standard lifetime interest rate cap is six percentage points above the introductory rate--so if the intro rate is 4%, the loan could never go higher than 10%. However, some loans cap at five percentage points above the start rate and others cap at eight points (or more) above the introductory rate.
* Adjustment periods: ARMs can adjust annually, semiannually or monthly. Annual adjustments are generally better when rates are rising, while monthly adjustments are preferable when rates are coming down.
* Payment caps: To avoid “payment shock,” some lenders offer to cap increases in your monthly payments. Great Western and Home Savings, for example, have 7.5% annual payment caps on their COFI loans. If interest rates boost your payment by more than 7.5%, the difference is added to the loan amount--a phenomenon called negative amortization.
For example, if you were paying $1,000 monthly on your $100,000 mortgage and rates popped up to the point where you would owe $1,200 monthly, the payment cap would kick in. You could opt to pay just $1,075, or 7.5% more than before, and add the $125 monthly difference to the balance due on the mortgage.
* Negative amortization: If negative amortization kicks in, your loan balance rises with each mortgage payment because your payment isn’t enough to cover the principal and interest due.
