How To Pick Adjustable Mortgages

June 04, 1989|By Jim DeBoth.

Q-We have been looking for an adjustable-rate mortgage but have had a hard time comparing. Please explain how they work.

A-Part of the problem is the seemingly endless variety of adjustable-rate mortgages (ARMs) available. Most common are the six-month, one-year, three-year and five-year programs.

First, you should acquaint yourself with the major terms: adjustment period, caps and index. ARMs usually are amortized (the life of the loan) over 30 years, but lenders denote the type of ARM by its first adjustment period. A three-year ARM pertains to a mortgage for which the first three years of the life of the loan the interest rate is constant.

The interest rate then will vary every year or every 3 years, depending on its characteristics. A 3-year ARM that varies each year after the first 3 years is called a 3/1 ARM, versus a `true` 3/3 ARM, which varies every 3 years. When shopping or comparing mortgage rates, one should note that a 3/1 ARM will have a lower rate than a 3/3 ARM.

The next concern is the cap period. A cap is the ceiling on an adjustable rate mortgage, the maximum interest rate. Typically, 1- and 3-year ARMs will have 2/6 caps, while 5-year ARMs almost always have 2/5 caps.

The first number refers to the current adjustment period`s limit. For example, at the end of the first 3 years of a 3-year ARM the interest rate could only jump 2 percent. If the interest rate was at 9 percent, it would rise by 2 percent, to 11 percent.

The second number refers to the maximum limit of the interest rate over the lifetime of the loan. A 2/6 cap on the 3-year ARM at 9 percent means that the lifetime limit of the loan is 15 percent.

Last, the fluctuation of the interest rate is based on the performance of an index. Lenders can have a variety of indexes as a base. The most common ARMs indexes are T-bills and the 11th District, Cost of Funds. T-bills react quicker to a changing market than COF indexes and can translate into a more volatile mortgage payment.