Money Matters - Simplified

Understanding Your Mortgage Rate

Fears of recession have the stock market reeling. But for homeowners with adjustable-rate mortgages, recent talk about possible cuts in interest rates is sparking celebrations.

There's a catch, though. Different mortgages peg the rates they charge to different interest benchmarks. And while some interest rates have already gone down, others are still rising.

ARM basics
The idea behind adjustable-rate mortgages is simple. Unlike fixed mortgages, in which you have a guaranteed interest rate throughout the life of the loan, rates on ARMs move up and down from time to time. Lenders often offer incentives to borrowers to take out ARMs by offering low "teaser" rates that may increase after a short time. For instance, US Bancorp (NYSE: USB) is currently offering a 5% rate on its one-year ARM. Fifth Third (Nasdaq: FITB) has a three-year ARM with a 5.5% rate.

For borrowers, that's fine as long as interest rates go down or stay the same. But when interest rates rise -- as they have over the past several years -- resetting ARM rates lead to much higher monthly payments. And with many homeowners up against the wall financially, the question is how quickly falling rates will work their way through to their mortgage payments.

Are rates rising or falling?
Unfortunately, answering that question isn't so simple. Banks calculate ARM rates by using other interest rates as a reference. The most common benchmarks used are the London Interbank Offered Rate (LIBOR), the 12-month average Treasury bill index (MAT or MTA), the 11th District Cost of Funds Index (COFI), and the constant maturity Treasury index (CMT).

What's making this question complicated right now is that these rates aren't moving in tandem. While Treasury bill rates have moved sharply lower over the past month, the LIBOR rate has remained at much higher levels. Currently, the three-month Treasury bill is hovering around 4%, while the corresponding LIBOR rate is at 5.7%.

Also, some ARMs are more sensitive to rate changes than others. If your ARM uses an average rate as its benchmark, then it'll take longer for lower rates to affect the average. On the other hand, if your ARM only looks at the current spot rate, then lower rates can bring relief much more quickly.

Know what you have
Eventually, these disparities in rates are likely to sort themselves out. In the meantime, though, if you have an ARM, you should look closely at your mortgage to find the provisions that govern how and when your interest rate and monthly payments will change.

In addition, you may want to take another look at fixed mortgages. As rates fall, these mortgages will become more affordable. So if a fixed mortgage was out of reach for you when you first bought your home, you might find that the option now compares favorably with your current ARM.

For most borrowers, falling interest rates won't bring immediate relief. But for some homeowners, reduced borrowing costs may mean the difference between keeping and losing their homes.

© 2007 Universal Press Syndicate.