- The Washington Times - Wednesday, October 1, 2003

Deciding between a fixed-rate and an adjustable-rate mortgage would seem to be one of life’s fundamental choices, like choosing between paper and plastic bags at the grocery store. Or is it? In today’s mortgage market, in certain situations, maybe you can have it both ways — if you’re careful.

“Mortgages have changed,” warns the Federal Reserve Board in its Consumer Handbook on Adjustable Rate Mortgages. “So have the questions that need to be asked and answered.”

What’s the difference?

A generation or so ago, nearly all mortgages had fixed rates. That meant the borrower would lock in at a particular interest rate for the life of the loan, usually 15 or 30 years. Fixed-rate mortgages were easy to plan and budget for and could guard against increases in mortgage rates. Even today, a fixed-rate mortgage is safe, secure and predictable. Plan to stay in your home for 20 years or more? A fixed-rate mortgage may be for you, especially given today’s low interest rates.

The problem is most people don’t stay in their homes that long anymore. Americans are moving much more often than they used to. Today, the average home stay is down to just six years, according to the National Association of Realtors.

What does that mean for your mortgage? It might mean that you opt for a different scenario.

Increasingly popular with today’s home buyers are adjustable-rate mortgages. As the interest rate fluctuates, so may your monthly payment. If you bank on interest rates generally dipping lower than they were at the time your purchased your home, an ARM will help you realize that advantage. Plus, they seem to be cheaper at the moment.

“ARMs offer better rates right now,” says Chadley Toregas, an agent with Coldwell Banker Pardoe’s Georgetown office. “They’re very popular.”

The ARM works by tying the interest rate to an index, such as Treasury bills, whose value may rise or fall over the life of the loan. Other indexes are based on norms such as certificates of deposit or the London Interbank Offer Rate. When a loan officer comes up with a rate for your ARM, he or she adds a margin of 2 to 4 percentage points to the index. From then on, adjustments are made to your rate after an initial adjustment period (anywhere from six months to 10 years), and then every six months to a year through the life of the loan.

Do you know which index is being used to calculate your interest rates? Do you know how it behaved in the past?

Generally speaking, rates for ARMs are still lower than they are for fixed-rate mortgages, meaning that you can get more loan for the buck. That lower rate can help you qualify for a larger loan or start you off with smaller payments.

“It’s easier to finance with an ARM right now, especially considering the better rates,” says Mrs. Toregas.

The number of homeowners choosing ARMs continues to rise, according to the Mortgage Bankers Association of America. ARMs are especially popular with people who expect their incomes to rise enough to handle any upward fluctuations in interest rates.

As home prices continue to climb, ARMs can offer you a little something extra. If you want to make the winning bid on the home of your dreams, you may have to consider an ARM in order to afford a bigger mortgage.

However, ARMs do come with a downside. For one thing, homeowners face the risk of running headlong into a situation where interest rates are rising, not falling.

Most mortgage brokers say they expect interest rates to do just that eventually.

ARM rates can rise up to 5 or 6 percentage points once the introductory period is over. That can be a significant amount of extra cash to give up.

In the first quarter of 2003, 4 percent of ARMs were paid more than 30 days late and half a percent entered foreclosure, according to an August 2003 report by Kathleen M. Howley in Bloomberg News. That is compared to a rate under 3 percent for late payments and a 0.2 percentage foreclosure rate on fixed-rate loans.

One-year ARMs, loans that allow for a rate adjustment after one year, offer rates that at first blush appear to be quite low — the lowest, in fact. Keep in mind, however, the odds are that interest rates will rise before you are ready to sell.

There are also other considerations to keep in mind. Will you be taking on other debts, such as car loans or college tuition, during the life of your ARM? How are payment increases tied to increases in interest rates? Most important, how long do you plan to stay in your home?

Suppose you expect to be in your home for about five years. That’s a familiar scenario to many folks these days. Given current conditions, you may suspect that interest rates will fall somewhat and not climb precipitously during that period.

In that case, an ARM may be for you. Most ARMs come with a set of provisions that prevent dangerous spikes in the interest rate. Caps limit the rate from rising a certain amount between adjustments, while ceilings prevent the rate from rising more than a certain amount during the life of the loan. However, payment caps don’t limit the amount of interest the lender is earning, so they may cause something called negative amortization.

Negative amortization occurs when your monthly payments are not enough to cover all the interest due. This means the interest shortfall is automatically added to your debt, and additional interest may be charged on that amount. You may be able to limit negative amortization by voluntarily increasing your monthly payment.

Looking to bail out of your ARM? You might want to consider a convertible mortgage, which allows you to switch to a fixed rate — for a fee, of course. Still, you’ll be protected from higher interest rates.

If you are a short-term homeowner, you can take advantage of the low rates in the meantime and sell your home before the higher rates kick in. Or you might want to consider a “two-step” loan, which starts out as fixed rate, usually for the first seven years, and then converts to an ARM, but if you stay in your home more than seven years, you could face much higher payments.

Recently, some Washington-area homeowners have been making use of combination loans, in which a certain percentage is counted at a fixed rate and a certain percentage is counted as an ARM.

“We didn’t see a lot of combination loans five years ago,” Mrs. Toregas says, “but right now, this a way to get a better deal.”

Some mortgages come with a balloon payment. Balloon loans are amortized over the traditional 30-year period, but they usually mature in five to seven years, making the borrower responsible for paying the entire outstanding principal after that time. This, as you might expect, could be an extraordinarily large sum.

So why choose a balloon loan? Well, if you are a short-term homeowner, you can actually sell your home before the balloon payment falls due, taking advantage of the lower interest rates that tend to characterize the early years of this type of loan.

After the balloon payment, you can opt to convert to a conventional fixed-rate mortgage, with rates set to those existing at the time of conversion. Of course, you’ll probably have to pay a conversion fee.

Refinancing offers many homeowners another way to change the type of loan. When interest rates reached a 45-year low last June, for example, many homeowners opted to refinance with a fixed-rate mortgage and lock in the low rate. Whenever the Federal Reserve cuts the interest rate, homeowners flock to refinance. Increasingly, though, refinancing comes with additional fees.

Then there are the hybrids. These loans start out as one thing and end up as another. For example, a hybrid loan may start out as a fixed-rate mortgage for a certain period of time and then convert to an ARM — but be careful: Some hybrid loans do not have a cap on the first adjustable-rate period, meaning that you could find yourself with higher payments than expected should interest rates have risen in the interim.

Another type of hybrid loan starts off as a fixed-rate loan but converts to a higher fixed rate at some point in the life of the loan. Here again, loans such as these are attractive to homeowners who plan to stay in their homes only for a short period.

Bottom line? Ask the right questions. Know your mortgages, and demand the answers that will help you make the best decision based on your financial situation and lifestyle.

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