The third step is to convert the rate and points for the remaining loans into their effective rate. Calculating the effective rate precisely requires a computer or financial calculator, but you do not need to be that precise to compare loans. The following formula works well for people who plan to keep their loan for 7 to 12 years:

Interest rate + (Points ÷ 6) = Effective rate

For example, the effective rate for ABC Mortgage Company's 8-percent plus 4.75-point loan is: 8 percent + (4.75 points ÷ 6) = 8.792 percent. (Note: This formula does not work with adjustable- rate mortgages.)

If you plan to keep your home for more than 12 years, divide the points by 8 instead of 6. If you plan to stay for four to six years, divide the points by 4. If you plan to stay one to three years, divide the points by the number of years.

The final step is choosing a low rate from a reputable lender. In the previous example, Hometown S&L has the lowest effective rate at 8.708 percent (see Figure 5.12). In the case of a tie, you can use fees as a tiebreaker, but in any event check a lender's reputation before submitting your application, and make sure that the lender can process and close your loan during the rate lock-in period.

Comparing ARMs

Comparing adjustable-rate mortgages is much more difficult than comparing fixed-rate loans. ARMs have so many different features that it is impossible to develop a simple formula for deciding which loan is best.

For ARMs, the interest rate is determined by the index, margin, points, fees, starting rate, and periodic and life interest rate caps. Without knowing what future interest rate levels will be, you have no sure way to know what the loan rate will be.

However, you should consider these critical elements:

• The maximum rate (life rate cap)

• The total index plus margin (your interest rate unless restricted by rate caps)

• The points and initial rate

• The possibility of negative amortization

The maximum rate is especially important because it determines the maximum monthly payment that you would have to make if high interest rates return. The monthly payment for a $100,000 mortgage is $878 at 10 percent versus $1,029 at 12 percent. The critical question with an ARM is “How much of a monthly payment can you afford?”

With ARMs, your interest rate is adjusted yearly (or periodically depending on the adjustment interval). The new rate is determined by adding the margin to the new index value. If two ARMs have the same index (most use the One-Year Treasury Security Index), then the loan with the lower margin is the lower rate loan.

With ARMs, points and initial rate are often traded one-for- one. For example, a lender might offer a choice of the same ARM with an initial rate of 6 percent plus two points or 5 percent plus three points. This is similar to a temporary buydown (see Chapter 6, “Miscellaneous Mortgage Topics”), but there is a difference. If the periodic and life interest rate caps are keyed to the initial rate (i.e., two and five caps), the maximum second-year payment and the life rate cap will be 1 percent lower for the loan at 5 percent plus three points than for the loan at 6 percent plus two points.

Before choosing an ARM over a fixed-rate mortgage, compare the current index value plus margin (i.e., 3.54 percent One-Year Treasury Index + 2.75 percent margin = 6.21 percent) to the current fixed-rate (i.e., 7.25 percent). The difference (1.04 percent) is the interest rate savings that you would get by choosing an ARM if interest rates were to remain the same. You should weigh this savings against the risk that the ARM's rate could increase to its maximum (i.e., 11.125 percent) if rates rise to high levels again. If you select an ARM loan that includes the possibility of negative amortization, you should consider the effect of interest being added to your original loan amount.

Submitting Your Application

After you have made your choice, move quickly to submit your application (see Figure 5.13). Rates can change daily! If you are canvassing lenders on Wednesday and Thursday, plan to submit your application on Friday. When you call to set up an appointment for the application interview, reconfirm the rate, points, and fees that you were quoted, and try to get an oral commitment to hold that price.

Review Chapter 1, “The Application Process,” so that you bring all the necessary documentation with you to the interview. All borrowers (e.g., both husband and wife) must sign the loan application, and some lenders require all borrowers to attend the interview.

A Final Note on Shopping

After you have applied for the loan, your lender probably will ask you for some additional documents or information. Make a log

FIGURE 5.13 Step 5: Submit Your Application

of when you received those requests, and respond quickly (keep track of when you responded). If your lock-in period expires and your lender tries to renege, you will have documentation to show that you complied with all requests.

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