Ask Dr. Don By Don Taylor, Ph.D., CFA • Bankrate.com

Deciding between adjustable-rate mortgage indexes

Dear Dr. Don,
I've been looking for 10/1 adjustable-rate mortgage programs. What are the pros and cons of one-year T-bills vs. one-year LIBOR index with 2.75 percent vs. 2.5 percent margins, respectively and same caps?
Tony T-bill

Dear Tony,
Adjustable-rate mortgages (ARMs) are priced on a variety of indexes. When the rate adjusts, it is changed to reflect the underlying index plus the pricing margin (or spread).

Some indexes such as the cost of funds index (COFI), lag changes in market interest rates while others such as LIBOR-indexed loans, stay more current. You can follow the movements in the indexes using Bankrate's Rate Watch feature.

When you borrow using a 10/1 ARM, you are locking in the interest rate over the first 10 years of the loan. The loan will have its first reset on its 10-year anniversary and then reset annually over the remaining life of the loan. The loan may also have lifetime and periodic minimum (floor) and maximum (cap) interest rates.

When comparing these loans, lay out a table that lists the index, the margin, periodic caps and collars, and lifetime caps and collars. Determine 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. It would be unusual for a 10/1 ARM to be structured with negative amortization, but don't make assumptions instead of reviewing the loan documents.

You also want to know if there is a prepayment penalty. The Federal Trade Commission offers a worksheet called Looking for the Best Mortgage? that will help you compare mortgages.

In comparing two loans that both have a 10-year rate lock, you should be less concerned about the differences between the indexes and more concerned about the initial rates and closing costs. Nobody knows where the two indexes will be 10 years from now and whether the economy with be in an upward rate environment or a downward rate environment. Odds are that you won't even have this mortgage 10 years from now, so focus instead on the costs over the 10-year horizon.