Right now, with interest rates at their lowest levels in decades, most homebuyers opt for fixed-rate mortgages, nailing down today's attractive rates.

But even so, sometimes a borrower's special situation makes an adjustable rate mortgage (ARM) the better choice.

Someone who expects to be in the new house for only a few years may go for the low initial rate on an ARM that's set to adjust after only three, or perhaps five, years. And those who expect steadily rising income (newly-graduated physicians, for example) might start with ARMs to qualify for more than they could otherwise borrow.

In order to compare different ARMs, you need a new vocabulary. First, who decides whether rates have gone up or down, when it's time to adjust your payment?

The figure used is a national (ital) index (end ital) of current rates, often those being paid by U.S. treasury notes or bills.

Next, the lender adds on a (ital) margin (end ital), for costs and profit (otherwise, why wouldn't they simply invest in no-risk treasury bills directly?). If the particular t-bill used as your index is currently yielding four percent, and your margin is 2 1/2 points, your new interest rate would be 6 1/2 percent.

Your ARM will have a (ital) cap (end ital), or (ital) ceiling (end ital), to protect you in of skyrocketing inflation in the future. Typically, you'll have a promise that come what may, your rate could never go above -- say --12 percent. And there will also be a cap on the amount by which it could be raised in any given adjustment. No matter what had happened to interest rates in the interval, your rate would never go up by more than -- for example -- two percent.

What happens, in that situation, to the higher interest you really should be paying? Be sure to inquire before committing yourself.

Does the lender just forget the shortfall and absorb the loss? Is it stored to be used at a later adjustment when your rate would otherwise drop? Or is the amount you didn't pay added to the amount you've borrowed? That latter is known as (ital) negative amortization (end ital) and while it's rarely encountered, you'd better make sure you understand what you're getting into.

Real Times Interest Rate Watch

Published: February 3, 1999

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