If you took out a mortgage within the last few years, there's a good chance it's an adjustable rate mortgage (ARM). According to USA Today, a record number of refinanced and new mortgages taken out in 2005 were ARMs, accounting for over a third of all mortgages. Properly evaluated and implemented adjustable rate mortgages can be powerful financial planning tools. A lower monthly payment can free up cash for investments. Improperly used, however, ARMs can be time bombs that go off when borrowers can least afford it. The beginning of the year is an ideal time to evaluate your ARM and its relationship to your financial, tax, and living situations.

Assessing Your ARM
ARMs are available in many different forms, but all ARM rates are determined using the same components: an index and a margin. The index is an external rate that reflects the conditions of money markets in general. According to the Federal Reserve, the most common indices are the 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR). The Financial Forecast Center anticipates that the 6-month LIBOR index will rise just over 0.3% to 5.75% by July 2007.

The margin is a percentage that the lender adds to the index and is usually between 2 and 5 percent. The sum of the index and the margin is the actual rate you are paying. This is called the fully indexed rate. So, if you have an ARM based on the LIBOR index with a 3 percent margin and you are due for an adjustment or reset in mid-2007, you could reasonably expect to be paying about 8.75%.*

Over the life of an ARM, you may pay several different rates. The start rate is usually a below-market rate, sometimes called a teaser. This rate may be effective for anywhere from a month for a monthly COFI ARM to several years for a hybrid ARM. It is crucial for homeowners to know when their rates will reset and what they will be paying when that happens.

Other important features of your ARM are the periodic cap and the life cap. The periodic cap determines the highest rate to which your ARM could increase in a single adjustment. If your current rate is 4% and your cap is 2%, your rate can only go to 6% this time, even if your index plus margin equals 8.75%.* The life cap is the highest rate you can be charged over the life of the loan, typically 5 to 7 points over your start rate. Most lending guidelines require that you be qualified either at the fully indexed rate or 2 points over the start rate. However, your rate could conceivably go as high as the rate cap, perhaps 6 points over the rate you paid initially and 4 points higher than what the lender determined that you could afford.

Negative Amortization: Purposes and Pitfalls
Some ARMs feature payment caps and negative amortization. In this situation, the borrower makes a payment based on an artificially low rate, often between 1 and 3 percent. The actual rate being charged is still a fully-indexed rate. So, if your fully indexed rate is 8.75% and you are making a payment based on a 1% rate, the difference gets added to your loan principal each month. For example, if you start with a balance of $300,000, your minimum payment based on a 1% rate is about $965. Your fully amortized payment at 8.75% is approximately $2,360. The lender adds the $1,395 difference to your balance. If you always make the minimum payment and rates don't change, you would owe over $317,000 at the end of the first year.* This is called negative amortization and means that the balance of your loan increases with each payment instead of decreasing as it does with a fully amortized loan. At some point, your loan may reset with a higher payment, a higher rate, and a higher balance as well.

Negative amortization isn't always "negative" or bad for consumers. A negative-amortization loan can provide short-term benefits if you understand how equity reduction occurs with this type of loan and if you are prepared to accept that tradeoff for a defined period of time. For example, you can use the equity in your home to keep your payments low for a limited time or to achieve a defined investment objective. However, if you used a 1% payment to buy more house than you can afford, you could find yourself in a bind. In Mortgage Payment Reset: The Rumor and the Reality, Christopher L. Cagan, Ph.D. reports that the mortgages facing the greatest risk of default are those with "very low initial rates, often with interest-only and negative-amortization features." For many homeowners, the house is their greatest asset, and erosion of equity or value can cause financial strain.

Other Interest Rates to Watch in 2007
Mortgage interest rates are not the only rates with which homeowners should concern themselves. The prime rate, which many credit card rates are tied to, is expected to rise as well. The Financial Forecast Center predicts that the prime rate will rise to 8.5% by mid-2007. If your credit card and other short term rates go up, you might want to consolidate them with either a cash-out refinance or a second mortgage. You may be able to obtain a lower fixed rate and a tax deduction as well.**

Should You Refinance in 2007?
Cagan concludes that, "If there is a problem set of mortgages, it is to be found among the adjustable loans undertaken in the last two years." How do you know if your loan is a problem? Consider these factors when determining if a mortgage refinance is appropriate for you this year:

• Is the rate you're paying now due for a reset in 2007? What will the payment be and can you afford it? If you are due for an adjustment, research the predicted values of your index, review your loan documents, find your margin, and estimate what you'll pay.
• How long do you plan to keep your property? This helps determine whether it makes sense to refinance into a fixed rate or a hybrid fixed for 3 to 10 years. It also may influence if you refinance at all.
• Is your current loan causing negative amortization and increasing your loan balance? A negative amortization loan can be appropriate when you expect a significant near term income increase, such as the proceeds of a sale, an inheritance, or a legal settlement. You can use your home equity to keep your payments low until you receive the extra money, then you should pay down the balance and refinance into a more stable loan.
• Are you worried about paying your bills and your mortgage? If you took out an ARM to buy more house than you could afford and now your payments are increasing, you might forestall trouble by refinancing your mortgage and consolidating other debt into a manageable fixed payment. Doing this before you find yourself in financial trouble can save money and your credit rating.
• Do you have a pre-payment penalty? Many borrowers are surprised to find out that they have a pre-payment penalty for refinancing a loan. In an article by Ruth Simon for the Wall Street Journal, Mark Thomson, Director of Consumer Services for the Washington State Department of Financial Institutions claims, "That??s one of the things we hear a lot: People go to refinance, and there??s a prepayment penalty on the original loan that they??re not aware of." Prepayment penalties can be a set number of months' interest or a percentage of the loan amount. Some penalties decrease each year that you have your loan. Check your documents and make sure that you don't have a pre-payment penalty. If you do, determine whether paying it and refinancing is still better than keeping your current loan.

The beginning of the year is a great time to review your finances and make changes where appropriate. Reviewing your mortgage, your financial position, and your life goals should be part of every financial checkup. Your mortgage should be part of your investment strategy and fit in with your goals. If it doesn't, now is a good time to consider refinancing into a loan that improves your overall financial situation.

Sources:

Federal Reserve Board

USA Today

Financial Forecast Center

Wall Street Journal

First American Real Estate Solutions