Choice can become a dirty word to harried home shoppers who are tired of making yet another decision. After having trudged through dozens of homes, they may be loathe to study all the mortgage options available to them. But the right loan may save you hundreds or thousands of dollars in interest costs.
“Twenty years ago, people only had a couple of choices (in mortgages),” notes Mick Rothblott, senior loan officer at Firstar Home Mortgage Corp., Deerfield, “and that was to take either a 15-year fixed-rate loan or a 30-year fixed.”
Lately, because interest rates have been relatively low, most borrowers have been gravitating to the fixed-rate loans, where the interest rate remains the same for the entire term of the loan. With a steady interest rate, homeowners are assured of steady, predictable mortgage payment amounts, and consumers love that security. In fact, notes Rothblott, borrowers tend to shun a whole class of other loans, known as adjustable rate mortgages (ARMs) unless interest rates on fixed-rate loans start to approach the double-digits or there is a significant difference (3 percentage points or more) between the initial rate of some ARMs and the rate on fixed loans.
But an ARM may be advantageous to you, regardless of the interest rate environment. If you are thinking about one you’ll need to understand the differences between the types and also know what consumer safeguards are offered.
The term “ARM” is usually preceded by a time period, such as one-year, or a group of numbers such as 5/1, or 7/23. These antecedents define when the ARM will adjust. For instance, the classic ARM model is the one-year ARM. That ARM starts out at one rate, usually at least a couple of percentage points below the prevailing rate on 30-year fixed-rate loans, but the low initial rate is only in place for one year. At the one-year anniversary of the loan, and at every annual anniversary thereafter, the rate on the loan can adjust.
How much and which direction–up or down–the rate can move each year depends on key factors laid out in the mortgage contract. One factor is the index, which by law must be a specified indicator of prevailing interest rates that the lender can’t control. Most lenders use the yield on U.S. Treasury securities as the index that governs the interest rate. Then they add a margin of a couple of percentage points to the prevailing Treasury rates to determine the new rate on your mortgage. However, nearly all ARMs contain “caps,” which ensure that the rate will not rise more than a certain amount at each adjustment.
The one-year ARM and the whole idea of adjustables came into being in the late 1970s and early ’80s, explains David Ginsburg, president of Loantech Inc., a Gaithersburg, Md., mortgage advisory firm. At that time, home buyers were desperate to find an alternative to the interest rate on fixed mortgages, which was hovering in the low to mid-teens.
Now, with a more palatable fixed-rate environment, lenders have rolled out new varieties of “hybrid” adjustable mortgages that combine some of the features of fixed and some of the adjustable. For instance, there are the 3-1, 5-1, and 7-1 loans. These mortgages start out at a fixed rate and then adjust every year after the initial three years, five years, or seven years, respectively.
“The 3-1 loan is the most competitive in terms of the starting rate,” notes Peggy Cortright, regional manager of Mortgage Market Information Services, Paoli, Pa. In early October, for instance, Cortright reports that the starting rate on the 3-1 was about 1.5 percent lower than prevailing rates on 30-year fixed loans.
Then there are loans like the 7-23, which has a slightly lower fixed-rate for the first seven years, and then will adjust to the prevailing rate on fixed-rate loans after the initial seven-year period ends.
Short-sighted?
“People choose the fixed-rate loans because that is what they’re comfortable with, but the fact is, unless you’re going to be in your home forever, the greatest bargains are with the adjustables,” Cortright says.
Mortgage borrowers should focus on their personal plans when choosing a loan. Indeed, a 3-1 mortgage is perfectly tailored to a family who knows that their move won’t be permanent, but that they’ll be transferred again within three years, explains Richard Ashmon, loan officer at LaSalle Home Mortgage Corp., Chicago.
Just as a real estate agent walks you through homes, a mortgage loan officer should take the time to run through the costs of one mortgage versus another, considering your personal plans. You may ask him or her to figure what you’d pay with a one-year ARM, for example, over the course of five years, given the worst-case scenario and your interest is adjusted to the highest possible level each year. Then, you could ask for a cost comparison with a 5-1 ARM or a 3-1 ARM.
Adjustable loans may also give first-time buyers the boost they need to afford a home, notes Rothblott. He points out that usually borrowers are qualified for a one-year adjustable not at the low initial rate, but at the highest rate it can be adjusted to on the first anniversary of the loan. However, “the Federal Housing Administration (FHA) has a one-year adjustable program that is wonderful for first-time buyers,” he says. The FHA loan can only rise 1 percent each year, and no more than 5 percent during the entire life of the loan, which is lower than the caps in place on other adjustables. What’s more, the lender qualifies the borrower at the first-year rate, rather than at the highest rate possible in the second year.
However, Dru Bergman, executive director of the DuPage Homeownership Center, a Wheaton group that helps first-time buyers, warns: “We are very cautious about adjustables. We deal with low- and moderate-income families who often plan to stay in their home for a number of years. Unless you are upwardly mobile and can realistically expect your income to go up, an adjustable can be risky because you may not be able to afford the higher payments” on down the line.
Consumer protections
Just as you would carefully inspect a house that you select before actually going through with the purchase, inspect the particular mortgage contract once you settle on a certain type of loan, advises Ginsburg.
Specifically, if you’re selecting an ARM, make sure it is one with caps, meaning that the amount that your adjustment can move up each year is limited. A two-percentage-point cap is common, meaning that if the initial rate is 6 percent, then the highest it can adjust upward in one year would be to 8 percent. Also look for a lifetime cap, which limits the amount the rate can rise over the life of the loan. Ginsburg says lifetime caps of 5 and 6 percent are common, meaning that an initial 6 percent loan could never rise beyond 11 to 12 percent, no matter how high prevailing interest rates are.
Shopping the particulars of a loan can help save you dollars, and studying the loan contract will also eliminate surprises later. For instance, notes Ginsburg, a number of lending companies have now begun to offer a slight reduction in the interest rate on some loans, but the mortgage contract includes a prepayment penalty if borrowers pay off or refinance their loan within the first few years.
NEED MORE INFO ON ARMS?
Here are some resources to learn more about which loan is right for you:
A free 23-page pamphlet, “Consumer Handbook On Adjustable Rate Mortgages,” is available by calling the Federal Reserve Bank of Chicago at 312-322-5111.
A newly updated 54-page booklet, entitled “How To Shop For Your Mortgage,” is available as part of a “Homebuyer’s Mortgage Kit,” which also provides a printout of mortgage rates by lenders in a locality. Call 1-800-873-2837 to order the $20 kit.
