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Ask Dr. Don
By
Don
Taylor,
Ph.D.,
CFA
•
Bankrate.com |
Choosing an ARM
Dear Dr. Don,
When one is comparing different lenders' five-year, seven-year or
10-year adjustable-rate mortgage offerings (at Bankrate.com, for
example), can one expect similar rate adjustment terms after the
fixed period ends? What's the standard spread offered on these ARMs?
Thanks,
George Gradation
Dear George,
The adjustable-rate mortgage offerings in your letter are a hybrid
form of financing. They lock in a mortgage rate for five, seven,
or 10 years before becoming one-year ARMs for the remaining loan
term.
ARMs are priced at a spread or margin to a base index.
After the initial fixed-rate period, the rate floats with the index.
Your loan documents will spell out how often the rate resets and
whether the loan has a cap (maximum) or collar (minimum) interest
rate for both when it resets and over the life of the loan.
The typical margin varies by the index used. ARMs
are priced based on the one-year Treasury Constant Maturity index,
the London Interbank Offered Rate (LIBOR) or the Federal Home Loan
Bank's 11th District Cost of Funds (COFI), among other indexes.
Bankrate tracks these indexes for you on its Rate
Watch page.
Because of competition between lenders, margins will
be fairly close for an index, but will vary across indexes. Margins
for the one-year Treasury constant maturity index range between
2.75 percent and 3.25 percent. That means that the interest rate
on your mortgage, when fully indexed, will be the rate on the one-year
Treasury constant maturity index plus 2.75 percent to 3.25 percent.
As I write this reply, the index is at 1.78 percent, so a fully
indexed mortgage would have an interest rate of 4.53 percent to
5.03 percent.
When shopping these loans, lay out a table that lists
the index, the margin, periodic caps and collars, and lifetime caps
and collars. Review whether the lender can include negative amortization
into the loan balance. Negative amortization refers to the loan's
interest rate not fully reflecting the interest expense. If the
loan permits negative amortization, this interest shortfall is added
to your outstanding principal balance.
You also want to know whether there is a prepayment
penalty. The Federal Trade Commission offers a worksheet called
Looking
for the Best Mortgage? that helps you compare mortgages.
The less time you plan on living in your home, the
more sense it makes to accept the volatility inherent in an adjustable-rate
mortgage. The hybrid mortgages that you're considering fix the rate
for a set number of years before becoming adjustable. This allows
you to get a lower rate than you would with a fixed-rate mortgage
because you're allowing the lender to shift some of its interest
rate risk back to you.
If you only plan on being in the home for as long
as the fixed rate holds, you've locked in a lower rate than you
could have with a fixed-rate loan. This Bankrate
feature lays out some of the pros and cons between adjustable-
and fixed-rate mortgages.
-- Posted: Sept. 27, 2002
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