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Look beyond the start rate.

Two credit card offers come in the mail. One has an intro rate of 5.99% and the other is 7.99%. Which offer is the best? You immediately go to the fine print that discloses that the first offer is 19.8% after 30 days and the second is 12.99% Obviously, offer two is more attractive. The same process should be applied when evaluating adjustable rate mortgages (ARM).

Most borrowers only choose based on start rate because they do not know how to evaluate different loans. Here’s how:

What is the Fully Indexed Rate?

Ask your lender to calculate the “true” rate by disclosing the rate after the discount period. The difference can be substantial.

Rates on ARMs are determined by two factors:

  1. Index-value based on market condition (treasury rates, Fed Rates, Certificates of Deposit)

  2. Margin-Constant value added to the index in order to determine the rate (“profit margin”).

Product
1 Year Treasury
6 Mo. Treasury
3 Mo. Treasury
Start Rate/Payment
6.5%
$1,264
6.25%
$1,231
4.75%
$1,043
Index
6.24%
5.98%
5.33%
Margin
2.50%
2.75%
1.75%
Fully indexed rate
8.74%
8.73%
7.08%
Full Payment
$1,572
$1,570
$1,341

* Note that rates change periodically, so call for latest rates.

Index

Ask your lender for a history of the index proposed. Indexes vary greatly according to how stable they are. To add stability, look for indexes that are based on an average (moving average). For example, an MTA is a “moving treasury average.”

Margin

A margin is the constant spread that is added to the index. If you want a lower rate for the life of your loan, look for a low margin. Margins are always overlooked by borrowers, and they vary from 1.75% to 2.875%.

Negative Amortization

This is often called “deferred interest,” and it indicates that payment may not fully cover the interest and principle required to pay off the loan in time. While this is often unacceptable to many borrowers, it is an option. The client can make the full payment based on the monthly statement. But beware: paying interest on interest can lead to long term hardship.