Some homeowners 'ARMed' and ready

Adjustable-rate loans, especially those with an interest-only component, recently have been shunned and criticized, hammered and nailed. If you are looking for sympathy in your daily life, simply mention at your kid's weekend basketball game that you have an adjustable-rate mortgage (ARM) set to adjust in May.

Ever since the mortgage mess began to unravel, consumers have raced to fixed-rate loans, reportedly with a newly found "pay-it-off" mindset. While this appears to be great news, it does not ensure that these same folks will not dip into their home's equity when the housing market eventually returns. That sort of discipline has yet to be proven among the baby boomers that have showed a tendency to refinance or take out a home equity loan for cars, vacations or a hot stock tip.

In reality, refinancing to a 30-year, fixed-rate loan may not be the best strategy for a homeowner looking for lower payments while hoping to reduce the principal.

For example, let's assume a working couple has a five-year, interest-only ARM with an interest rate of 6 percent. When an ARM adjusts, the index and margin are added to arrive at the new interest rate. The index for the loan (the financial gauge that determines the loan's interest after it adjusts) is the one-year LIBOR, 2.12 percent at press time. The margin (the amount added to the index to ensure a lender's profit and cover costs) is 2.25. Combine the two numbers and the couple's new interest rate is 4.37, lower than their initial interest rate. The couple could take the amount saved each month and apply it to the loan's principal, thereby creating a fully amortized loan.

Loan advisor Tom Lasswell clarifies that allowing an ARM to adjust may be the best avenue for borrowers, especially if they are planning to remain in the home for only a short period of time. According to Lasswell, borrowers too often are swayed by the "flavor-of-the-month" loan, which may or may not be the best loan for them.

And, many consumers are also unaware that they can make extra principal payments every month on their interest-only loan. Most borrowers, even those with significant prepayment penalties, can make lump-sum payments to their principal balance as long as the lump sum is not greater than 20 percent of the current mortgage balance. For example, if a borrower had a $300,000 loan with a prepayment penalty, most of the time the borrower could pay $60,000 directly toward principal without triggering the penalty.

In a recent column, we discussed the case of a young woman with excellent credit and a decent job who bought a home four years ago. She was dinged with a new "risked-based" premium when she attempted to refinance due to a late credit-card payment on a company card she had had her name on at a previous job.

Why not just let her ARM adjust, make the new payment after the adjustment, and then refinance to a fixed-rate loan when her credit issues were resolved? The gamble would be the possibility of a higher fixed-rate loan environment down the road. Rates now are at historic lows, and loan officers and "the media" have been eager to promote the benefits of fully amortizing loans rather than the "just renting" element attached to interest-only mortgages. ...CONTINUED

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