Variable-rate, also called adjustable-rate, mortgages (ARMs) can also be compared, except that many more factors are involved. The first thing you’ll notice is that the interest rates usually will seem much lower for ARMs than for fixed-rate loans. Once again, don’t be fooled. Remember, compare apples with apples, not with oranges.
The low initial interest rate (often called the teaser) is the traditional appeal of ARMs. As such, they appear to be giving you a better deal. But it isn’t necessarily so.
There are a number of different factors to take into account when comparing variable/adjustable-rate mortgages. We’ll cover six of the most important:
■ Teaser rate
■ Caps
■ Indices
■ Margin
■ Adjustment period
■ Steps
What Is a Teaser Rate?
Most ARMs have a low beginning interest rate. This is usually only a teaser, a come-on to get you to sign up for the ARM. Often the teaser is several percentage points below the true rate. What this means is that in the first few adjustment periods, your effective interest rate will rise even if interest rates in general do not!
As an example, the discounted teaser rate may be 4 percent and the true market rate may be 7. You get the ARM at 4 percent. However, if it has 3-month adjustment periods with a maximum adjustment of 1 percent in interest each period, within 9 months it will be up to 7 percent. Your interest rate will go up 1 percent the first 3-month period, 1 percent the second 3-month period, and 1 percent the third 3-month period, so that 9 months after you get the loan you are paying 7 percent instead of 4.
Additionally, some of these loans are written in such a way that the interest rate will continue on up to make up for the below-market interest rate you received as part of the teaser. So your interest rate could continue on up beyond 7 percent for a time!
Remember, the teaser rate is only temporary. Don’t be fooled into thinking that it is the true rate of your mortgage. Ask the lender what the true rate is. You’ll be shown the APR (annual percentage rate), which will be higher than the teaser but probably still not as high as the current market rate of the mortgage (because the APR is a blending of the teaser and the current mortgage rate).
When comparing ARMs, it’s usually to your advantage to go for the one where the teaser lasts the longest, thus maximizing your period of low interest rates.
What Are Caps?
Adjustable rates often have caps limiting the maximum amount that the interest rate can rise over the term of the loan and the adjustment period. Rate caps prevent the interest rate on a variable rate mortgage from rising indefinitely.
Some loans offer payment caps, where the amount the monthly payment can rise (to compensate for a rising interest rate) is also capped. It sounds like a good idea, but in reality it can be a trap. Monthly payment caps often lead to negative amortization, which, simply put, means that you end up owing more than you originally borrowed!
Negative amortization happens when the interest rate goes up and your monthly payment does not. In this case, each month you may not be paying enough to meet just the interest on the mortgage, let alone repaying the principal.
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