Deciphering ARM, fixed-rate mortgages

With mortgage rates rising but home prices still going up, what should you do about refinancing or taking out a new home loan? What kind of loan should you get a fixed-rate or an adjustable-rate mortgage? If you go the ARM route, do you understand all the complexities of how that type of borrowing works?

Those questions still baffle millions of current and would-be home owners, but there are ways to master the right answers. First, though, you need to know beforehand that if the rate changes and your monthly payment goes up, you can adequately prepare for the higher costs.

Take the case of one woman reader who's about to get a 10/1 ARM loan for $278,400 plus one point from a lender. The rate is guaranteed at 5.699 percent for 10 years, after which the lender could add maybe up to five percent to the rate.

Another lender just called her to say he had a better deal a 5/1 ARM whose rate wouldn't change for five years and would save her $600 a month.

The average person isn't able to figure the better deal in his or her head. Instead, it'll take a calculator to compare the two offers, showing exactly how much in interest and principal the woman would pay off in five or 10 years under either plan, and what the loan balances would be in years 2009 and 2014. What will her financial situation probably be then? That's the answer.

Learning the basics: With a fixed-rate mortgage, the interest rate stays the same during the life of the loan. But with an ARM, the rate changes periodically, usually in relation to an index such as Treasury securities, and payments go up or down accordingly. Lenders generally charge lower initial rates for ARMs than for fixed- rate loans.

This makes the ARM easier on your pocketbook at first, and means you might qualify for a larger loan because lenders sometimes make their decision based on your current income and the first year's payments. Also, an ARM could be less expensive than a fixed rate over a long period for example, if interest rates remain steady or decline.

Having an open mortgage can be a plus for your credit score, according to Experian, one of the top three credit rating agencies. A national study just found out that consumers holding a mortgage averaged 716 on their score, versus 667 for those who didn't. Reason: Those with a mortgage show potential lenders they've been creditworthy in the past.

Meanwhile, some key things about ARMs you need to know:

Adjustment period With most ARMs, the rate and the monthly payment change every year, every three years, or every five years. However, some ARMs have more frequent rate and payment changes, and nowadays even seven- and 10-year ARMs are also more common. The period between one rate change and next is called the "adjustment period.' A loan with an adjustment period of one year is called a one-year ARM, and so on.

Margin To determine the ARM rate, lenders add a few percentage points to the index rate. The amount of the margin may differ from one lender to another, but it is usually constant over the life of the loan. It's the main thing that affects your monthly payment.

Discounts Some lenders offer initial ARM rates that are lower than their "standard' ARM rates (that is, lower than the sum of the index rate and the margin). Such rates are often combined with large upfront fees and higher rates after the discount expires. In return, the buyer gets a lower rate and lower payments early in the mortgage term. This is sometimes called a "seller buydown,' but beware the seller may increase the price of the home to cover the cost of the buydown.

Finally, with an ARM always ask the lender upfront about loan "caps' the limit on the amount that your rate can increase and "negative amortization' that occurs whenever mortgage payments aren't large enough to cover all the interest due.

Robert K. Heady is co-author of "Complete Idiot's Guide to Managing Your Money.' He invites mail on consumer money problems but cannot respond to all inquiries. E-mail jrnl8888@aol.com or write to P.O. Box 14875, North Palm Beach, Fla. 33408.

What are people saying about mortgages today:

Rates on 30-year mortgages edged down last week to a seven-month low. Mortgage-giant Freddie Mac reported Thursday that 30-year, fixed-rate mortgages fell to 6.3 percent, down slightly from 6.31 percent two weeks ago. It put rates at the lowest level since they were at 6.24 percent the first week of March.

Bank of Hawaii, Central Pacific Bank, Territorial Savings Bank and Wells Fargo Home Mortgages all cut their 30-year mortgage rates to 5.75 percent this week.

Most people think of a mortgage as a means to an end. After all, you buy a house, not a home loan. But a mortgage is much more than the path to homeownership. It is a financial instrument that must be managed, just like any other financial investment.