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2006: A look back - A look ahead  
  Mortgage rates and home prices rose in 2006 while a refi boom is anticipated in 2007.
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5 ways to assess risk of your option ARM

"The thing no one realizes is the rate is fixed for only 30 days," Ohlbaum says. "The payment is fixed, and that's nice -- but the rate isn't."

As the introductory interest rate doubles, then triples, then quadruples and even quintuples, the minimum payment rises a maximum of 7.5 percent a year. Some borrowers may find that, when they make the minimum payment, their loan balance increases more than $1,000 each month.

Most option ARMs are indexed to the average yield on one-year Treasuries in the past year -- an index known as the one-year MTA. That average has been rising steadily and will continue to rise. The rate on the loan is calculated by adding the one-year Treasury average to a margin that varies from loan to loan.

For an example of how this works, look at the one-year MTA on Bankrate's summary of Treasury securities. On Sept. 6, the one-year MTA was 4.664 percent. If your margin is 3 percentage points, your rate equals the index plus the margin: in this case, 7.664 percent. One month before, the fully indexed rate was 7.563 percent, and a year before it was 5.64 percent.

If you got an option ARM without understanding these basics, it's time to learn. The main thing you need to know is this: Since the one-year MTA is based on average one-year Treasury yields for the past year, and one-year Treasury yields have been rising in the past year, it is sure to keep rising into late winter and probably longer.

2. You exaggerated your income on your application.
A lot of option-ARM borrowers have stated-income loans, in which the lender doesn't verify the amount that the borrower claims to earn. For auditing and fraud-fighting purposes, borrowers sign a document that allows the lender to do a spot-check with the Internal Revenue Service.

In July, National Mortgage News reported that an unidentified lender took a random sample of 100 stated-income loans, looked at the borrowers' tax returns and discovered that 90 of the borrowers had lied. Thirty exaggerated their incomes by between 5 percent and 49 percent, and 60 borrowers had puffed up their incomes by 50 percent or more. Just 10 told the truth. The lender didn't say how many of these stated-income loans were option ARMs.

Bottom line: If you lied about your income, you're more likely to find that you don't earn enough to pay your debts.

3. You regularly have been making minimum payments.
If you have been making minimum payments most months, you're not paying down your debt and might, in fact, be increasing it. You feel this not only in your pocketbook, but in your gut.

-- Updated: Nov. 1, 2006
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