We now want to extend the discussion to adjustable-rate mortgages and balloon loans.

Step 4A: FORMULATE A PRICE SELECTION STRATEGY FOR ADJUSTABLE-RATE, BALLOON MORTGAGES

Both adjustable-rate mortgages, or ARMs, and balloons have fixed rates for some initial period. For balloons, that period is almost always either five or seven years. For ARMs, it can range from a month to 10 years.

If you know that you will be out of the house before the initial rate period ends, you can use the same price selection strategy as on a fixed-rate mortgage. As far as you are concerned, it is a fixed-rate mortgage. In using calculator 9c to measure interest cost, enter the initial rate period as the period "you expect to stay in your house." The calculator will ignore what happens after that period.

The problem is that virtually no one can be certain that they will be gone by the end of any initial rate period. Life has a bad habit of changing our minds. You should be aware of what can happen at the end of that period and factor that into your decision process.

In the case of balloon loans, that is not difficult. At the end of the initial rate period, you must refinance at the market rate prevailing at that time. Since all balloons are equally bad in that regard, select the one that is the best deal over the initial rate period. 

ARMs, however, have built-in protections against rate increases after the initial rate period, and these may differ from one ARM to another. If two 5-year ARMs have the same interest cost over the five years, you want the one that exposes you to the least risk of rate increases at the end of five years. 

Unfortunately, this is not easy to determine because it is affected by a number of ARM features: the rate adjustment period after the initial rate period ends, the interest rate index used by the ARM, the margin added to the index in determining the new rate, caps on rate adjustments, and the maximum rate allowed over the life of the contract. If the ARM allows negative amortization, other features are relevant as well. 

While the government under Truth in Lending mandates that this information be disclosed, it does not mandate that it be understandable, let alone presented in a useful format, or that it be available to shoppers. The sad fact is that a very large proportion of ARM borrowers haven't a clue as to might happen to their ARM at the end of the initial rate period. Many loan officers don't either; they view "what might happen" as a downer that doesn't belong in their sales pitch.

To assert control, print out "Information Needed to Evaluate an ARM" from my Web site, and have the lender fill it in for any ARM you are considering. You then have what you need to use calculators 7b or 7c, and 9a or 9b. These calculators will tell you what will happen to your interest rate and monthly payment at the end of the initial rate period if 1) the interest rate index doesn't change; 2) the index goes through the roof (a "worse case"); or 3) the index follows any other future scenario you choose to examine.

Sometimes when you compare two ARMs of the same type, you find that one has a lower initial cost than the other but also offers less rate protection at the end of the initial rate period. There is no formula to guide you in making this decision, except "Discuss it with your partner."