Major red flag of adjustable real estate loans

Adjustable-rate mortgages (ARMs) are becoming increasingly popular with borrowers, and the cost of borrower ignorance about ARMs is growing with it. Every day I encounter misperceptions that have led to bad decisions, or are about to.

To avoid getting trapped into a bad ARM, it is very useful to understand the difference between the interest rate and the fully indexed rate (FIR).

The ARM interest rate is the rate you see: it is the rate quoted by the loan provider, and the rate shown in the media. It is the same as the rate on a fixed-rate mortgage, with one difference. The ARM rate holds only for a specified initial period. That period can be as short as a month, and as long as 10 years. At the end of that period, the rate is adjusted.

The FIR is the rate you don't see. It is never quoted, never shown in the media, and is not a required disclosure. Yet it is the major indicator of what will happen to the rate at the end of the initial rate period.

If the initial rate period is long and the borrower expects confidently to be out of the house before it is over, the FIR is unimportant. But if the initial rate period is short, or if there is a reasonable probability the borrower will still have the mortgage when it ends, the FIR is critically important to the borrower.

The flexible-payment, or "option" ARM, which has been growing in popularity, has an initial rate period of one month. It is a favorite instrument of hucksters because they can advertise rates as low as 1 percent. They don't bother to mention that this rate holds only for the first month. The FIR, which provides the best clue as to what the rate may be in the 359 months that follow, is seldom volunteered.

The FIR is the current value of the rate index used by the ARM, plus a margin, which varies from one transaction to another, but stays the same through the life of any one ARM. For example, a widely used index on monthly ARMs is COFI, standing for cost of funds index. If the current value of COFI is 2.5 percent, as it was in April 2005, and if the margin on a particular loan is 3 percent, the FIR on that loan is 5.5 percent.

The FIR is usually the best prediction of the rate at the first rate adjustment, which is month 2 on a monthly ARM. If the index does not change between month 1 and month 2, the rate in month 2 will be the FIR.

That is important information for the borrower to have. If you are choosing between two ARMs that are otherwise the same, you take the one with the lower FIR.

If two ARMs use the same index, you only have to compare the margins because the index values will be the same. I don't advise using this shortcut, however, because sometimes indexes with the same names are different. For example, the loan provider may tell you that the index is "Treasury" or "Libor," but there are several different indexes that fall under each of these headings.

Even if the index is the same, furthermore, lenders may define the "current value of the index" differently. While some indexes (such as COFI) are only available monthly, a number of Treasury and Libor series that are used as indexes are published monthly, weekly and daily. If one lender uses the latest monthly average while another uses the latest weekly average, their FIRs won't be comparable.

To make sure two FIRs are comparable, proceed as follows:

1. Ask the loan provider for the margin ? in writing. You don't want any nasty surprises at the closing table.

2. Ask the loan provider to identify the index used from a list that you give him. Copy and paste the following URL into a Web browser: http://www.mtgprofessor.com/A%20-%20ARMs/arm_indexes.htm, and then copy the list.

3. Find the most current value of the index yourself. (The Web page cited above shows online sources for all the indexes listed there.) Just remember that if you are comparing ARMs with different indexes, the period used should be the same. They should both be monthly values for the same month, weekly values for the same week, or daily values for the same day.

Yes, you could ask the loan officer to do this for you; it is his/her job, after all. The loan officer's interests may not coincide with yours, however, so if you want to be sure it is done right, do it yourself.

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

Copyright 2005 Jack Guttentag