- The Washington Times - Wednesday, April 20, 2005

Q: We are considering refinancing our $275,000 home loan to a 3/1

adjustable-rate mortgage at 4.25 percent. The annual percentage rate is 4.60 percent.

We would be paying 2.5 points and rolling them into the loan.

I am confused about what can happen at the end of three years. It is my understanding that the rate can jump to 4.60 percent or as high as 6.25 percent, depending on where interest rates are at the time.

I think this is a good deal, but my husband thinks we may have to refinance in three years even if we pay the points. How can we get a clear understanding of what will happen to this mortgage at the end of three years?

A: Your situation is a perfect example of why it’s important to have a good loan officer to help you through the mortgage process. Whoever is selling you this loan did not put enough effort into his explanations because it’s clear that you need more understanding before you commit to the refinancing.

A 3/1 ARM is a mortgage with a 30-year term. The initial interest rate is fixed for three years, and then it adjusts annually for the remaining 27 years.

At the end of the third year, the rate will adjust based on a predetermined index and margin. The index is the rate that the mortgage program follows at the time of adjustment. A common index is the one-year Treasury bill yield. The margin is the predetermined amount that is added to the index to determine the new mortgage rate, usually about 2.75 percentage points.

Let’s say that the index of this loan is the one-year treasury bill yield and that the margin is 2.75. Now let’s say that in three years, the one-year T-bill is yielding 3.50 percent. Add the index and margin to determine the interest rate, and we come up with 6.25 percent in year four.

At the beginning of year five, it adjusts again in the same fashion.

Most ARMs have annual and lifetime “caps” that prevent the rate from going too high. Typically, you’ll see two-percentage-point annual caps and a six-percentage-point lifetime cap. This means the rate cannot increase by more than two percentage points each year and cannot exceed six percentage points over the start rate, or 10.25 percent (4.25 + 6.00), for the life of the loan.

That’s a quick summary of how adjustable-rate mortgages work.

Now let’s address a couple of other issues.

Your husband says you may have to refinance in three years, even if you pay points. First, the only way you would be forced to refinance is if the mortgage program carries a “balloon” feature. This means the loan must be paid in full within a specified period of time.

Loans that balloon in only three years are rare. The most common types of balloon loans are the so-called “two-step” programs, which carry a fixed rate for five or seven years and balloon at the end of the fixed-rate term. Called 5/25s or 7/23s, they usually give the borrower an option to convert the loan to a fixed market rate instead of paying it off.

So I’m pretty sure your husband is incorrect about refinancing. Whether you pay points would have nothing to do with a balloon feature — one has nothing to do with the other.

Speaking of points: In a word, don’t. Two and a half points on a $275,000 loan equates to $6,875 in nonrefundable fees. If you don’t pay the points out of pocket, your loan balance increases to $281,875.

You lose $6,875 in equity.

It never makes sense to pay points on a short-term adjustable rate. Remember that paying points “buys down” the interest rate. If the interest rate you’re buying down is good for only three years, you can make a safe bet that you won’t recoup the costs of the points before the rate can jump up.

It’s better to take a higher rate with no points charged.

The last thing I want to talk about very quickly is the annual percentage rate. The APR is designed to give the consumer an idea of total borrowing costs after taking into consideration the costs associated with obtaining the loan. The problem is that the APR uses some assumptions when it determines costs.

To make matters more confusing, calculating the APR on an adjustable-rate mortgage is useless because there’s no way of knowing where the rate will be in the future.

Clearly, an accurate APR cannot be determined.

The guy who gave you an APR of 4.60 percent is surely making an assumption that your rate will drop in three years. Using my computer to calculate your APR with the assumption that rates will remain the same in three years, I come up with 5.93 percent. The points are killing you.

My advice would be to seek out recommendations from trusted advisers (family, friends, co-workers). Perhaps they can point you toward an experienced and competent loan officer who will assess your current mortgage situation; ascertain your objectives; and then make recommendations of what, if anything, to do.

Henry Savage is president of PMC Mortgage in Alexandria. Contact him by e-mail (henrysavage@pmcmortgage.com).

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