Don't Be Alarmed If You Have An ARM

Don’t Be Alarmed If You Have An ARM

With economists projecting several interest rate hikes through 2006, financial advisers say now is the time for borrowers to take a second look at the loan terms of adjustable-rate mortgages. “Rates are likely to trend upward over the next year or two,” warns Allen Fishbein, director of housing and credit policy for the Consumer Federation of America, a consumer advocacy group. “If consumers have less flexible incomes and don’t have the resources to draw on to cover rising monthly payments, then ARMs may not be the best choice.”

Last year, U.S. Army Capt. Samuel Williams and wife, Toni, a district manager at Target, chose a two-year adjustable-rate mortgage over a fixed-rate mortgage when they decided to build a five-bedroom, two-story home in San Antonio. Williams, who is the personnel manager with the San Antonio Recruiting Battalion, could be transferred before he is eligible for retirement in about two and a half years. The ARM, which has a starting fixed rate of 5.8% for two years, allowed the Williamses and their 2-year-old daughter, Jasmine, to afford a larger home than if they’d chosen a higher rate 30-year fixed mortgage. Thanks to the ARM, says Williams, “If we stay in San Antonio, we won’t have to buy another house. We can grow into this one.”

An adjustable-rate mortgage generally has a fixed-interest rate for a set number of years at the beginning, then the rate fluctuates. The fluctuations, called adjustments, boost or drop the initial interest rate and can occur monthly, quarterly, semiannually, or annually. ARM adjustments generally average 2% or less for borrowers with the best credit scores and can average up to 5% a year for borrowers with a credit score below 600.

The appeal of an adjustable-rate mortgage is that a borrower can cut his initial interest rate and initial monthly payments by one to two percentage points depending on the duration of the loan’s fixed period. However, in a rising rate environment, monthly mortgage payments could soar.

Borrowers who have existing ARMs shouldn’t worry. A quarter percentage point increase in the prime interest rate causes only an eighth of a percentage point increase in mortgage rates. In fact, Clarence Lewis III, a mortgage broker with Motown Mortgage in Houston, points out that “when the [Federal interest rate] moves, it doesn’t necessarily mean that mortgages will move.” He notes that mortgage rates didn’t increase significantly in 2004 because the economy didn’t grow very fast and because the dollar has remained weak.

Borrowers should read their loan agreements carefully to understand what will spark an increase in their mortgage rate and by how much. The interest rates of many ARMs aren’t attuned to the prime interest rate but to bank deposits in specific regions of the country or to international indexes such as LIBOR (London InterBank Offered Rate). Lewis says borrowers should find out the volatility of the index used to calculate their loan’s mortgage rate, calculate the maximum possible adjustment in their monthly payments as their specific index rate climbs, and determine whether