The Federal Reserve put out a helpful little consumer guide this week, and you don't have to know anything about industrial production and capacity utilization to understand it.
The new handbook explains adjustable-rate mortgages (or ARMs), along with some of the pitfalls associated with these increasingly popular and increasingly complicated loan arrangements. The handbook starts with two simple points about ARMs that are so plainspoken, they could have been written right here in Fooldom:
"Your monthly payments could go up -- sometimes by a lot -- even if interest rates don't go up." And: "Your payments may not go down much, or at all -- even if interest rates go down."
That doesn't mean adjustable-rate mortgages should be avoided. They may be the perfect loan for you. It just means that when choosing an ARM, like any other financial product, you should know exactly what you're getting into.
In its simplest form, an ARM is a mortgage with an interest rate that adjusts periodically. The initial rate is typically lower than a fixed-rate mortgage. That makes them attractive to many buyers. People who know they will not live in their new home very long, in particular, can get a significant financial advantage from choosing an adjustable-rate mortgage.
The Federal Reserve, however, has been concerned that promises of low payments may be luring some consumers into mortgages that don't make financial sense. Among those potentially questionable loans are interest-only mortgages, which require the borrower to pay only the loan interest during the first few years. That means the homeowner builds no equity, even though the early payments might be smaller.
Another potentially worrisome type of loan the Fed has highlighted is the payment option ARM, which gives borrowers the choice of paying as much as they want, as long as they pay a monthly minimum. Here's the catch: That minimum may not be enough to cover that month's loan interest.
Among the pitfalls highlighted by the Fed that some of these more exotic ARMs might pose for consumers:
- Discount rates or teaser rates. A lender may offer one of these extra-low rates, often in combination with discount points, but it may not last long. The teaser rate may not bring down your overall loan costs, and you might be better off with a slightly higher rate that lasts longer. You may also not be able to afford the higher payments after the loan rate adjusts.
- Payment shock. This is your reaction when you open the envelope from your lender to find out your rate and your monthly payment have gone up -- a lot. Make sure you understand when and by how much your rate could increase.
- Negative amortization. This dry-sounding term describes a truly horrifying scenario where the total amount you owe increases even though you make every required payment on time. This can happen when your monthly payments don't cover your interest costs and the unpaid interest gets added to the loan balance. It can also happen if your loan has a payment cap.
- Prepayment penalties. These can be a problem if you want to refinance. If your loan is very restrictive, they can even be a problem if you sell your home.
The Foolish message: Don't be dazzled by talk of unbelievably low interest rates or rock-bottom monthly payments. They may not be good for you or your bank account. Also, make sure you understand all of the fine print in any mortgage or loan agreement.
If you're shopping for an ARM, the Fed booklet has a worksheet you can use to make sure you nail down the details of each. Comparing loans with different terms can be tricky. Once you have all the information collected, you can use The Motley Fool's calculator to find out "Which loan is better?"
A recent issue of the Motley Fool GreenLight newsletter, yours with a free 30-day trial, answered even more questions about adjustable-rate mortgages. The personal finance gurus discussed whether now's the right time to refinance your ARM and offered some helpful hints for cutting your refinancing costs.
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