All about ARMs

While the double-digit interest rates that created them are gone, adjustable-rate mortgages still offer financial flexibility for borrowers who need it.

When interest rates soared into the double digits in the early 1980s, many people were completely priced out of the home-buying market. Lenders responded with a new kind of loan that tied mortgage interest to a variable index, such as U.S. Treasury Bills, in order to go below conventional loan rates. They tacked on an extra 2 percent or 3 percent--known as the margin--to originate the loan and the adjustable rate mortgage was born.

Because their interest rates are two to three points below conventional fixed-rate mortgages early on in an ARM, adjustable-rate mortgages are still an option for buyers stretching their budget to get into a home. In exchange for a low rate in the beginning of the loan, you must be willing to accept a monthly payment that can fluctuate, unlike a fixed-rate loan where the monthly payment is locked in.

That's because these loans are tied to indexes that go up and down. However, ARMs don't adjust every month. Most are adjusted every year or every three years and within proscribed limits, all of which should be spelled out clearly in your loan agreement. Because terms of adjustable loans can be complicated, it's important to understand how they work. Here are the key features you should know before you talk to a lender:

ARM talk: What's in an adjustable loan

Initial Interest Rate: Starting rate of an adjustable loan; Can be one to four points lower than conventional 30-year, fixed-rate mortgage.
Adjustment Interval: How often the loan's rate can be changed; Can range from six months to three years; new rate equals index plus margin.
Index: Financial markets rate that measures lender's cost to borrow; used by lender as basis for loan rate; Goes up and down in response to interest rates; best indexes are those that are the least volatile. How long will it take for the rate on the ARM to reach the maximum allowed under the loan program?
Margin: Set percentage added by lender to index rate to calculate final loan rate; Can range from one to three percent on individual loan; stays the same during life of the loan.
Interest Caps: Limits on amount that interest rate can be increased when loan adjusted; Lifetime caps, required by law, limit rate changes over life of loan; periodic caps limit rate changes between adjustment intervals; cap amounts widely vary.
Payment Cap: Limit on amount that monthly payment can be increased; Limit set at a percentage of previous payment; undesirable because it can result in negative amortization.

Know your limits

When considering an adjustable-rate mortgage, always look at the worst-case scenario:

How long will the initial interest rate remain in effect?
What will the interest rate be after the first adjustment?
How high can the interest rate go if interest rates continue to rise?
How long will it take for the rate on the ARM to reach the maximum allowed under the loan program?

An adjustable-rate mortgage that adjusts only once a year but has a higher initial rate may cost you less than one that adjusts twice a year but has a lower start rate. ARMs that adjust only once a year also have the benefit of enabling you to prepare for monthly payment adjustments. Six-month adjustments can be more difficult to handle.

TIP: Paying points to buy down the initial rate on an ARM may be a waste of money because the start rate is in effect for a short time. If you are going to pay points, use the money to buy down the margin on the loan, which will save you money over the life of the loan.

Understanding indexes
Indexes are pegged to overall interest rates. The best choices for an index on an adjustable mortgage are the least volatile ones, that is the least vulnerable to frequent or major swings in interest rates. Also, the longer the term of the index, the more the borrower is protected from short-term interest rate fluctuations. For example, an ARM with a six-month U.S. Treasury bill index is more volatile than one with a one-year index. Federal Cost of Funds or the 11th District Cost of Funds indexes (known as COFIs) are considered the least volatile. Other popular indexes include Treasury securities (known as T-bills) and LIBOR (the London Interbank Offer Rate).

Having it both ways
Lenders have devised many options for combining the affordability of an ARM with the certainty of a fixed-rate loan. A hybrid mortgage, for example, has fixed and variable rates that kick in on a schedule. For example, you might pay a fixed rate (usually a quarter to half percent below prevailing fixed rates) for the first five, seven or 10 years of the loan, then go to an adjustable schedule for the rest of the loan. Another option is to include a clause in your loan agreement that lets you convert your adjustable loan to a fixed-rate mortgage at designated times. You probably will pay a interest rate or upfront fees for a convertible loan, but this can be a good option for a cash-strapped buyer who needs the adjustable's lower rate early on.

Teaser rates
Many lenders offer initial interest rates that are lower than the fully indexed rate (the index rate plus the lender's margin, or profit). These teaser or discount rates are for a limited time only after which the fully indexed rate would apply. Be sure you understand the difference and plan for the change.

Prepayment penalties
Many adjustable mortgage agreements allow you to pay the loan in full or in part without penalty whenever the rate is adjusted. But some impose penalties. If possible, negotiate for no penalty or as low a penalty as possible. Prepayment details are sometimes negotiable. If so, you may want to negotiate for no penalty or for as low a penalty as possible.