Compare Adjustable Rate Mortgages

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You have to focus on several critical issues that don't come up when you buy a house with a fixed-rate mortgage.

The initial interest rate that applies until the first adjustment. If an advertised rate looks too good to be true, it's probably a "teaser" rate that's less than the fully indexed rate. "Believe it or not, lenders on the West Coast are offering initial rates of 0% for three months-a sales ploy to get the phone to ring," says Fannie Mae's Tom Smith. While such an offer can grab your at tention, it should also trigger some healthy skepticism.

The index, or market benchmark, that will determine your rate adjustment. Indexes vary in volatility. The two most common are the One-Year Treasury Constant Maturity series and the 11th District Cost-of-Funds Index (Cofi, or "Coffee"). According to Jack Guttentag, a professor emeritus of finance at the Wharton School and the creator of Mtgprofessor.com, those two indexes have been about the same on average, although the Cofi is much less volatile. When interest rates increase, a less volatile index-one that doesn't go up as fast-would be appealing.

The next interest rate--the one you'll pay after the first adjustment. This is the index value on the adjustment date plus the margin-typically 2% to 3%. If the margin is 2.75% and the Cofi is 1.8%, for example, your new rate would be 4.55%. If you take an ARM with a teaser rate that is less than the current index plus the margin, you're almost guaranteed a rate hike when your first adjustment rolls around.

The length of time before the first adjustment, and the adjustment interval after that (typically monthly, every six months or annually). For example, the introductory rate might last for six months and adjust annually thereafter.

Interest-rate caps, which govern the first adjustment (typically capped at 1% to 5% over the initial rate), subsequent changes (typically capped at 1% to 2%) and the maximum increase over the life of the loan (typically no more than 5% to 6% above the initial rate). They spell out your worst-case scenario.

Say that you get a 5/1 ARM with a 5% initial interest rate, a 2% annual cap and a 5% maximum cap. When your rate adjusts at the end of year five, it could rise to no more than 7% for year six and no more than 9% for year seven. In no event would the rate ever exceed 10%. (To determine how likely a scenario this is, you need to check the history of your index. The Cofi, for example, has increased more than two percentage points annually only once since 1969, and that was in 1981.)

With so many different variations, shopping for an ARM can be tough. Be sure you check with several different lenders to find the best deal for you.