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Ask Dr. Don
By
Don
Taylor,
Ph.D.,
CFA
•
Bankrate.com |
Adjustable-rate mortgage loans
Dear Dr. Don,
I recently purchased a home and was shopping around for the best
interest rates. Since the 30-year fixed rates has been climbing up
the past five weeks I decided to go with a FHA ARM (adjustable rate
mortgage). The rate I received on the ARM was 4.5 percent compared
to a 30-year fixed rate at 6.25 percent. I was told that the FHA ARM
can increase up to 1 percent every year starting January 2005, and
the most is 5 percent for the life of the loan. I plan to live in
the home for about five to 10 years.
My question is if it's possible
that it can increase 1 percent every year, or if it gradually increases,
like a quarter percent or half a percent instead of a percent? Please
let me know if I made a wise decision.
Chian Conundrum
Dear Chian,
When fixed rate mortgages start heading higher, borrowers look
to adjustable-rate mortgages (ARMs) to keep their mortgage interest
rate low. The problem is that it doesn't keep the rate low since
the interest rate will reset periodically.
With a one-year ARM the interest rate will reset annually.
You've stated that your mortgage's first reset is in January 2005
and that the mortgage has a lifetime cap of 5 percent over the initial
rate and an annual cap of 1 percent. The caps are standard to this
FHA product. Here's more about the FHA ARM product from the FHA
library:
Designed to assist first time home buyers, the FHA
251 is a 30-year adjustable rate mortgage. This ARM is tied into
the one-year Treasury Bill with adjustments annually (determined
by the index and the interest rate margin that is set at the time
the loan is originated). There is a 1 percent annual interest rate
cap (that could increase or decrease) and a 5 percent cap over the
life of the loan. Translation: The adjusted interest rate cannot
move higher or lower than 1 percent per year and no more than 5
percent over the life of the loan. Furthermore, the borrower must
qualify at an interest rate 1 percent greater than the initial mortgage
rate.
Your loan's interest rate will reset at a spread to
its pricing index. FHA adjustable rate loans are priced at a spread
to the one-year Treasury bill rate. By knowing both the spread and
the prime rate at the reset date you know the new rate. Review your
loan documents for the pricing spread and the pricing index. Between
now and the first reset date you can track movements in your pricing
index using Bankrate's Track
Rates feature.
Don't count on small fluctuations in interest rates,
especially with your first reset. The first reset will fully index
the rate subject to any interest rate caps.
Time will tell whether you made the right decision.
The pricing spread and changes in the pricing index will affect
the probability that your loan rate gaps higher at every reset date.
Meanwhile you've got an adjustable-rate loan at 1.75 percent below
what you could have gotten as a fixed-rate loan. That gives you
until at least January 2006 before the rate on your adjustable mortgage
could exceed that fixed rate.
-- Posted: Sept. 2, 2003
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