Little-known facts about adjustable rate mortgages
Julie Garton-Good, GRI, DREI

Home buyers this season may take more than a casual look at adjustablerate mortgages. This is due in part to rising interest rates andincreasing home prices. But there's much more than just interestrates to consider with adjustable rate mortgages.

Here are some little-known facts about ARMs:

  1. ARMs are the most likely loans for the lender to keep in portfolio(which means keeping the loan in-house and not selling it to outsideinvestors in the secondary market). This is because interest ratesfluctuate on ARMs, covering both the lender's cost of doing businessplus profit. Portfolio lending can be a positive for home buyersbecause they may be able to sidestep some of the requirementsof the secondary market and obtain concessions on qualifying ratios,down payments and private mortgage insurance;
  2. If an ARM program has an option to convert to a fixed-ratemortgage, it adjusts not to current market rates, but based ona formula that generally creates a higher-than-market interestrate. This means that the fixed-rate you convert to could be substantiallyhigher than the current fixed rate at the time of conversion.Be sure to ask the lender upfront what its conversion formulais based on, and ask to see a sample calculation;
  3. Shopping for the margin is just as important as shopping forthe index, since the margin remains constant for the life of theloan, no matter how the index fluctuates. For example, if thelender tells us the index is 4 percent and the margin is 2.75percent, those two figures added together gives us an interestrate of 6.75 percent on the loan. While the index may change fromyear to year (rising and falling with inflation), the margin remainsconstant. So all things considered, you'll save the most moneyover time if you shop for the lowest margin when you originatethe loan;
  4. As a marketing tool, a lender can provide a start rate or"teaser" rate, which is a deeply discounted first-yearstart rate for the loan. While there is nothing wrong with takingthis lower rate, make sure you know which rate your payment adjustmentswill be based on (the teaser rate or the note rate) so that youaren't "shocked" by a substantially higher payment whenthe loan adjusts.

By keeping these little-known ARM facts in mind, you can choosethe most affordable loan, eliminate surprises and be assured thatyou've made a wise financial choice in financing your home purchase.