ADJUSTABLE RATE MORTGAGES

Adjustable rate mortgages (commonly referred to as ARMs), can be a useful tool for savvy home buyers. Or they can be a real headache for those who haven't done their homework.

Simply put, an adjustable rate mortgage is one in which the interest rate will change. The extent to which the rate changes depends on a variety of factors, including the index to which mortgage rates are pegged, as well as the terms of the mortgage contract itself.

Adjustable rate mortgages are attactive in that they initially offer lower interest rates than fixed rate mortgages. For someone who is planning on staying in the home for a short period of time, an adjustable rate mortgage can save a substantial amount of money. For someone who's planning on staying in the home for a long period of time, an adjustable rate mortgage may not be the best option.

If you think that an adjustable rate mortgage is right for you, it still pays to do your homework. ARMs offered by various lenders can vary greatly in their terms and costs. You will need to know about indexes, margins, discounts, rate caps, amortization, and more.

You also need to ask yourself some questions. Can you afford a higher monthly mortgage payment if rates go up? Are there other debts--car loans, student loans, etc--that you'll be taking on soon? How long do you plan on living in your home? Because rates on adjustable rate mortgages can go up, and sometimes significantly, you need to factor in all of your expenses in case mortgage rates rise significantly.

With most lenders, the initial rate and monthly payment on an adjustable rate mortgage will remain the same for a certain length of time. This initial period is called the "adjustment period."

The mortgage rate that you get on an ARM is not the same as an annual percentage rate (APR). The APR takes into account other factors, such as points and fees. Ask your lender what the APR is on your adjustable rate mortgage. If it's significantly higher than the mortgage rate you're being quoted, you could wind up paying a lot more every month after the adjustment period, even if interest rates do not change.

Just like fixed rate mortgages, the interest rate on an adjustable rate mortgage is based on two factors: the index and the margin.

The index is usually pegged to the prime interest rate (the rate banks charge each other for lending money), U.S. Treasury bills, constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), the London Interbank Offered Rate (LIBOR), or other financial instruments.

The margin is the amount that the lender charges over and above the index. The margin may be 1/2 of one percent, one percent, or any other amount. The margin is basically the lender's profit.

If the index to which your rate is pegged goes up after the adjustment period, so will your payments. If the index goes down, your payments may go down, but not always. Be sure to ask your lender if your payments will go down in such a situation.

The amount of margin you pay on your adjustable rate mortgage can be affected by several factors, including your credit score. You may be able to reduce the margin, and thus your interest rate, by making sure that your credit record is up to date and correct.

If you take out an adjustable rate mortgage, how much can your rate go up?

Most ARMs have a cap on the interest rate increases. A periodic adjustment cap limits the amount the rate can go up from one adjustment period go another. A lifetime cap limits the amount that the interest rate can go up over the full term of the mortgage. By law, all adjustable rate mortgages must have lifetime caps.

Some adjustable rate mortgages allow for a larger rate change at the first adjustment period, and then have periodic adjustment caps to all future adjustments. For example, let's say that you have an initial rate of 5.5% on a three-year ARM. At the end of your initial adjustment period (three years), your interest rate could jump to over 8%, even if interest rates in general have not risen that much. That's why it's very important to do your homework when shopping for an ARM.

Some adjustable rate mortgages have caps that can hold your interest rate below the amount that the indexes increase. For example, let's say that the index (U.S. Treasury bills, LIBOR, etc) goes up by 2%. The cap on your adjustable rate mortgage may limit your rate increase to 1.5%. But the increase that you did not get because of the cap can be carried over to another rate adjustment period. Lenders call this "carryover." To recover that .5%, the lender may increase your interest rate at the next adjustment period, even if the index at that time hasn't changed.

Another type of cap on some adjustable rate mortgages is a cap on payments. A payment cap limits the amount that your monthly payment can increase. Let's say that interest rates rise dramatically (4%, for example), but you have a payment cap on your ARM. Your monthly payment can only increase by the amount set by your payment cap.

However, the lender has to recover the cost of the dramatic interest rate increase, or he wouldn't be able to stay in business. So, the difference between the dramatic rate increase, and the lesser rate increase that you received, will be added to the total amount of your mortgage. In other words, while your monthly payments didn't increase as much as overall interest rates, the amount you owe on your mortgage will increase. This is called "negative amortization."

ARMs with payment caps may not have periodic interest rate caps. Also, most payment-option ARMs have a defined recalculation period. This is usually once every five years. At that recalculation period, your payment will be recalculated based upon the remaining term of the mortgage. The payment cap does not come into play at this point. If your mortgage balance has increased, or if general interest rates have gone up faster than your payments, your monthly payments after this recalculation period could go up significantly.

To get an estimate of how much your payments can vary with an adjustable rate mortgage, try our Adjustable Rate Mortgage Calculator.

There are a variety of adjustable rate mortgage plans on the market. If you're comfortable with the idea of your interest rate or monthly payments not being fixed, you should discuss the various mortgage plans with your mortgage lender or broker.

And, as always, do your homework.