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Surviving a Jump in Your Adjustable-Rate Mortgage

Posted on: Tuesday, 13 December 2005, 15:00 CST

By JEFF BROWN

First, the bad news: If you're among the millions who took out an adjustable-rate mortgage in the past few years, your monthly payment is likely to rise on the next adjustment date - by 20 percent, 30 percent, even 40 percent. Blame the Federal Reserve for driving up short-term interest rates.

But there's good news, too: You can still get a good deal refinancing to a 15- or 30-year fixed-rate mortgage. Thank the bond market, which has defied the Fed and kept long-term rates low.

ARMs have been hot for the past couple of years because their low first-year payments allowed homeowners to borrow more as home prices soared. Now it's time to pay the piper.

The typical ARM adjusts every 12 months by adding a "margin" - often 2.75 percentage points - to an underlying index such as U.S. Treasury notes with one year left to maturity.

A year ago, those notes carried rates of around 2.6 percent. So an ARM that adjusted at that time has probably charged about 5.35 percent.

The string of Fed rate hikes since June 2004 has driven the one- year Treasury to about 4.34 percent. So an adjustment now would go to about 7.1 percent - a 32 percent increase.

On a $200,000 loan, the monthly principal and interest payment would jump from $1,117 to $1,358.

Many people who took out ARMs in 2004 at rock-bottom "teaser" rates of 4 percent or less will now see their rates soar 50 percent. (Most ARMs limit adjustments to two percentage points a year and six percentage points over the loan's life.)

As I said, the good news is that you can still get a 15-year, fixed-rate loan for around 5.5 percent, and a 30-year one for just under 6 percent.

Figure how much you can save per month by refinancing. If you'd have the new loan long enough for that saving to offset the refinancing costs, do it.

Remember that the Fed probably is not finished raising short- term rates, so your ARM could go even higher a year from now. If you wait until then to refinance, fixed-rate loans may be charging more as well.

There's another way to tackle the problem: by making a big principal payment, reducing the size of the loan and thereby cutting the monthly payment at adjustment time.

ARM payments are figured by applying the new interest rate to the remaining loan balance and term.

Supposeyou were five years into a 30-year ARM and, after 60 payments, had paid off $20,000 of the $200,000 you had borrowed. The new payment would be figured by applying the new rate against $180,000 for 25 years.

But if you paid an extra $30,000 to principal before the adjustment, the new rate would be applyed to a $150,000 balance for 25 years. Obviously, the payment would be smaller.

This possibility is often overlooked because most borrowers are more familiar with fixed-rate loans. With those, extra principal payments do not reduce the required monthly payment. The benefit comes from paying off the loan faster.

Of the two approaches, refinancing is probably best, because it means locking in a relatively low fixed rate. Paying down principal will cut your monthly payment. But you'd still risk facing higher payments later if interest rates continued going up.

To figure the best course, use a mortgage calculator. There are good ones on the Web at bankrate.com and hsh.com.

***

Jeff Brown is a syndicated columnist for Knight Ridder News. His column appears every Tuesday in The Record.

Source: Record, The; Bergen County, N.J.

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