Be Ready to Feel the Pinch from Your ARM

A study this past year bythe Federal Reserve saidthat 35% of people withadjustable-rate mortgages(ARMs) didn'tknow when their rates would reset orthe potential maximum they might payon those loans. For some people whorefinanced 1, 2, or 3 years ago—particularlythose who went with interest-onlyloans—an increase based on currentrates could raise the size of the paymentas much as 60%.

Don't want to get caught with a rateadjustment nightmare? It may happen,but at least you can prepare. Keep thefollowing questions in mind:

•Do you know whether youhave an ARM? It may sound silly, butif you're not sure, check. Fixed-ratemortgages carry an interest rate thatstays the same during the life of theloan. But with an ARM, the interestrate changes periodically based on yourloan agreement, usually in relation to aparticular financial index. Paymentsmay go up or down depending onwhere that index is heading.

•When's my adjustment period?If you've already signed on the dottedline, dig out those mortgage documentsand look for the margin. The margin isthe percentage amount the lender addsto the index rate to get the ARM's interestrate. With most ARMs, the interestrate and monthly payment change everyyear, every 3 years, every 5 years, orpossibly longer depending on what youagreed to. The period between one ratechange and the next is called the adjustmentperiod. A loan with an adjustmentperiod of 1 year is called a 1-year ARM,and the interest rate can change onceevery year. You need to ask your lenderhow much warning you'll get about anapproaching adjustment period andhow your current payments may beaffected.

•Did you get an introductoryrate with your loan? During theheight of the mortgage boom, lenderstook a cue from credit card companiesby offering customers a lower rate duringthe first year of the ARM. Whenthat rate goes off, it's quite a shock.Realize that you'll have to adjust to thepossibility of significantly higher paymentslater on, especially if interest rateskeep heading up. Make sure you understandthe relationship of any introductoryrate to a permanent rate.

•What's the cap? On most conventionalARMs, the lender caps thepercentage increase in the interest rate.It's very important to ask your lender—or review your loan documents—abouthow your rate cap works on your particularloan. Interest caps come in twoversions: periodic caps, which limit theinterest-rate increase from one adjustmentperiod to the next, and overallcaps, whichlimit theinterest rateincrease over thelife of the loan.Ask whether thereare any other conditionsunder whichyour monthly paymentmight change.

•Are there restrictions on prepaymentand conversion? For borrowerswith lower credit scores or thosewho had to go to subprime lenders,there may be interesting language inyour loan agreement restricting prepaymentor converting your loan to a fixedrate whenever you want. Obviously, atsome point you might need to create anescape plan, and if you got stuck withthis language, figure out how much thedivorce is going to cost.

Reprinted with permission from the Financial PlanningAssociation (www.fpanet.org), the membership organizationfor the financial planning community.