Purchasing a foreclosure is a great way to get a good bargain on a home these days. Many people are getting huge homes at small home prices. Unfortunately, many home buyers do not know what is involved with buying a foreclosure and they end up with a bad experience. Here are four questions you should ask yourself before you purchase a foreclosed property.

1. Is a foreclosure right for me?

If you have never purchased a foreclosure or a home for that matter, you should seriously consider the work that often goes into buying a foreclosure. Many foreclosed homes need repairs in order to be brought up to code and it will be up to you to make those repairs. Home buying experts suggest that if you are a first time homebuyer, a foreclosure may not be ideal for you. But if you are willing to roll up your sleeves and do some work on the house and put some money into it, a foreclosure can be a great bargain.

2. Do I have the financing to make it happen?

Buying a foreclosure is much like buying a regular home. You should have your financing prepared to go so when you see a foreclosed property that you want, you can jump on it right away. You should know how much of a monthly payment you can afford and it helps to be prequalified for a mortgage before you begin your house search so you can put together an offer when you see the home you want to buy.

3. Does my real estate agent specialize in foreclosed homes?

Buying a foreclosed home is similar to buying a regular home, but there are a few differences. It’s important to have a real estate agent that knows the ins and outs of buying a foreclosed property. A real estate agent can point you to the best title companies and a knowledgeable team of closing professionals and make the process much more smoothly. The paperwork for buying a foreclosed home is also slightly different and it is important that it is filled out right when you make your offer for the best possible results.

4. Can I get a traditional real estate property for the same price?

The prices of homes in most of the country these days are much lower than they were a couple years ago. As a result, there are many homes on the market that you can purchase at a great bargain. Do you want to go through the hassle of buying a foreclosed property if you can get a non-foreclosed property for about the same price?

Buying a foreclosed home can have many advantages. If you educate yourself on the process and the possible work involved after you move in, you can get a great deal and save thousands of dollars on your purchase. Just be sure that you know what you are getting into before you make your final purchase offer.

Click here for information on the current mortgage rates in your area.

Buying a home is going to be one of the most important decisions you will ever make. Unfortunately, many home buyers take this decision too lightly and they jump into it without taking the proper steps to save money and make an educated purchase. Here are four things you should do to financially prepare for a home purchase so you don’t make an impulse decision that could cost you thousands more than necessary.

1. Reduce Your Debt
Debt is one of the main obstacles to getting decent mortgage rates when you decide to buy a home. If you have credit card debt, medical bills or other consumer debt, put your plans of buying a home on hold until you can at least pay down your debt considerably. Many financial experts suggest that you pay off as much debt as you can before applying for a mortgage as debt-to-income ratio is one of the three main things mortgage lenders evaluate. The lower this ratio at the time you apply for a mortgage, the better risk you are going to be.

2. Make Virtual Payments
Start putting money is savings as soon as possible after paying off your debts. To practice paying a mortgage, you should do this the same time each month. Pretend that you already have a mortgage payment to get accustomed to making your payments on time so you will be well-versed in that when you finally purchase a home. Use this money for your down payment when you find the house you want to buy.

3. Improve Your Credit
One big mistake that first-time home buyers make is not knowing their credit score before applying for a mortgage. You can get free credit scores through various websites and since your credit score is one of the determining factors in getting a mortgage loan, you should know what it is before you apply. There may be things on your report that drag your overall score down, and inaccurate information may cause a lower score than what you should have. Take care of these things and improve your score as much as possible before you apply for a mortgage loan, even if it means postponing your home purchase. It’s better than getting a high mortgage rate and paying more than you need to over the term of your loan.

4. Visit Open Houses
Many home buyers do not know what homes are worth. That’s why it is important to visit open houses that realtors have. You can see what homes are worth in your area so you can plan your budget accordingly, and avoid waiting until it’s time to buy to find out that you can’t afford a decent-sized home that will accommodate all of your family’s needs.

With the proper preparations, you can make an informed decision rather than an impulse one. There is nothing wrong with taking some extra time to make sure you make a good decision on the most important purchase of your life.

Click here for information on the current mortgage rates in your area.

Buying a home can be a complicated process. There are documents to file, processes to follow and much more to ensure that the transaction is a smooth one. In many cases, having an attorney working on your side can help you out immensely.

Hiring an attorney to work for you when you buy or sell a home isn’t required. However, it does decrease your chances of a lawsuit after the transaction is completed. This is especially true when you are seller – for example, many home sellers have been sued because they didn’t disclose all of the necessary information about things like the home inspection that could affect the buyer’s decision to purchase the house. As a seller, your attorney will review your home’s inspection to make sure all of the relevant information is reported to the buying party. As a buyer, too, your attorney can readily find out if there are any liens, judgments or other legal problems with the house that could cause problems after you purchase it.

Another benefit to hiring an attorney is so you can make sure all of the papers are filed properly at all levels of jurisdiction, including the county and state levels. The deed is one of the most important papers to file once a house is sold. You can, of course, file this yourself. But if you don’t do it properly, you found face unforeseen tax or other financial consequences.

One of the most important reasons to have an attorney working on your side is so they can be there to give you any legal advice that you may need. Your mortgage lender and real estate agent might try to give you legal advice, but only lawyers can give legal advice because they have the knowledge and expertise to do so.

Hiring an attorney when you are buying or selling a home is going to be an extra expense. However, the expense of the attorney could be miniscule compared to the problems that can be caused if you don’t file papers properly or if you buy a house without knowing that there is a tax lien or other type of judgment against it. In many cases, your realtor can suggest a qualified attorney or you can ask family and friends for referrals if they have used the services of an attorney lately.

Click here for information on the current mortgage rates in your area.

Many home buyers believe that if you are married and you want to apply for a mortgage, you have to apply jointly as a couple and you cannot apply as a buyer yourself. While most couples would want to have a joint mortgage, for couples where one spouse has horrible credit, it could be advantageous for only one to apply for the mortgage.

When a couple applies for a mortgage, the lender looks at both incomes, and the combined debt-to-income ratio and credit scores. They will combine all of these figures to determine if the couple is a favorable risk. For instance, if your spouse has a credit score of 600 and you have a credit score of 800, your combined score will be 700.

A lender has three basic criteria that it wants in a borrower: low debt, good credit history and a stable job and income. If you have all three of these yourself and when combined with your spouse you may not, you may be able to qualify for a mortgage yourself instead of as a joint venture.

On the other hand, applying for a joint mortgage has its benefits and can cause you to jointly qualify for a mortgage or a better mortgage when either spouse may independently lack one or more criteria for a favorable mortgage. Having both spouses on a mortgage also has psychological and other benefits. How would you feel if your spouse’s name was the only name on the mortgage and you were having troubles in your marriage? You have no legal right to the property because it is not in your name. Or what if your spouse suddenly dies and only their name was on the mortgage papers? You might be able to stay in the home, but it would probably have to go through probate or additional hassles. When both names are on the mortgage, it just creates fewer problems all around even if you have to pay a little higher interest rate to make it happen.

It is also important to note that some states, such as Illinois, both names must be on a home’s title if you are married. Many mortgage lenders will require that the title holders are all listed as mortgage holders. It therefore is best to check with a mortgage lender in your local area to determine if it is even possible to have a mortgage in just one spouse’s name if you are married.

Click here for information on the current mortgage rates in your area.

An adjustable-rate mortgage (ARM) is a loan with an interest rate that changes. ARMs may start with lower monthly payments than fixed-rate mortgages, but keep in mind the following:

• Your monthly payments could change. They could go up--sometimes by a lot--even if interest rates don't go up.
• Your payments may not go down much, or at all--even if interest rates go down.
• You could end up owing more money than you borrowed--even if you make all your payments on time.
• If you want to pay off your ARM early to avoid higher payments, you might pay a penalty.

You need to compare features of ARMs to find the one that best fits your needs. The Mortgage Shopping Worksheet can help you get started.

What is an ARM?

An adjustable-rate mortgage differs from a fixed-rate mortgage in many ways. Most importantly, with a fixed-rate mortgage, the interest rate stays the same during the life of the loan. With an ARM, the interest rate changes periodically, usually in relation to an index, and payments may go up or down accordingly.

To compare two ARMs, or to compare an ARM with a fixed-rate mortgage, you need to know about indexes, margins, discounts, caps on rates and payments, negative amortization, payment options, and recasting (recalculating) your loan. You need to consider the maximum amount your monthly payment could increase. Most importantly, you need to know what might happen to your monthly mortgage payment in relation to your future ability to afford higher payments.

Lenders generally charge lower initial interest rates for ARMs than for fixed-rate mortgages. At first, this makes the ARM easier on your pocketbook than would be a fixed-rate mortgage for the same loan amount. Moreover, your ARM could be less expensive over a long period than a fixed-rate mortgage--for example, if interest rates remain steady or move lower.

Against these advantages, you have to weigh the risk that an increase in interest rates would lead to higher monthly payments in the future. It’s a trade-off--you get a lower initial rate with an ARM in exchange for assuming more risk over the long run. Here are some questions you need to consider:

• Is my income enough--or likely to rise enough--to cover higher mortgage payments if interest rates go up?
• Will I be taking on other sizable debts, such as a loan for a car or school tuition, in the near future?
• How long do I plan to own this home? (If you plan to sell soon, rising interest rates may not pose the problem they do if you plan to own the house for a long time.)
• Do I plan to make any additional payments or pay the loan off early?

Lenders and Brokers Mortgage loans are offered by many kinds of lenders--such as banks, mortgage companies, and credit unions. You can also get a loan through a mortgage broker. Brokers "arrange" loans; in other words, they find a lender for you. Brokers generally take your application and contact several lenders, but keep in mind that brokers are not required to find the best deal for you unless they have contracted with you to act as your agent.

How ARMs work: the basic features

Initial rate and payment

The initial rate and payment amount on an ARM will remain in effect for a limited period--ranging from just 1 month to 5 years or more. For some ARMs, the initial rate and payment can vary greatly from the rates and payments later in the loan term. Even if interest rates are stable, your rates and payments could change a lot. If lenders or brokers quote the initial rate and payment on a loan, ask them for the annual percentage rate (APR). If the APR is significantly higher than the initial rate, then it is likely that your rate and payments will be a lot higher when the loan adjusts, even if general interest rates remain the same.

The adjustment period

With most ARMs, the interest rate and monthly payment change every month, quarter, year, 3 years, or 5 years. The period between rate changes is called the adjustment period. For example, a loan with an adjustment period of 1 year is called a 1-year ARM, and the interest rate and payment can change once every year; a loan with a 3-year adjustment period is called a 3-year ARM.

Loan Descriptions Lenders must give you written information on each type of ARM loan you are interested in. The information must include the terms and conditions for each loan, including information about the index and margin, how your rate will be calculated, how often your rate can change, limits on changes (or caps), an example of how high your monthly payment might go, and other ARM features such as negative amortization.

The index

The interest rate on an ARM is made up of two parts: the index and the margin. The index is a measure of interest rates generally, and the margin is an extra amount that the lender adds. Your payments will be affected by any caps, or limits, on how high or low your rate can go. If the index rate moves up, so does your interest rate in most circumstances, and you will probably have to make higher monthly payments. On the other hand, if the index rate goes down, your monthly payment could go down. Not all ARMs adjust downward, however--be sure to read the information for the loan you are considering.

Lenders base ARM rates on a variety of indexes. Among the most common indexes are the rates on 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR). A few lenders use their own cost of funds as an index, rather than using other indexes. You should ask what index will be used, how it has fluctuated in the past, and where it is published--you can find a lot of this information in major newspapers and on the Internet.

To help you get an idea of how to compare different indexes, the following chart shows a few common indexes over an 11-year period (1996-2008). As you can see, some index rates tend to be higher than others, and some change more often. But if a lender bases interest-rate adjustments on the average value of an index over time, your interest rate would not change as dramatically.

The margin

To set the interest rate on an ARM, lenders add a few percentage points to the index rate, called the margin. The amount of the margin may differ from one lender to another, but it is usually constant over the life of the loan. The fully indexed rate is equal to the margin plus the index. If the initial rate on the loan is less than the fully indexed rate, it is called a discounted index rate. For example, if the lender uses an index that currently is 4% and adds a 3% margin, the fully indexed rate would be

	Index		4%
+	Margin		3%
Fully indexed rate			7%

If the index on this loan rose to 5%, the fully indexed rate would be 8% (5% + 3%). If the index fell to 2%, the fully indexed rate would be 5% (2% + 3%).

Some lenders base the amount of the margin on your credit record--the better your credit, the lower the margin they add--and the lower the interest you will have to pay on your mortgage. In comparing ARMs, look at both the index and margin for each program.

No-Doc/Low-Doc Loans When you apply for a loan, lenders usually require documents to prove that your income is high enough to repay the loan. For example, a lender might ask to see copies of your most recent pay stubs, income tax filings, and bank account statements. In a "no-doc" or "low-doc" loan, the lender doesn't require you to bring proof of your income, but you will usually have to pay a higher interest rate or extra fees to get the loan. Lenders generally charge more for no-doc/low-doc loans.

Interest-rate caps

An interest-rate cap places a limit on the amount your interest rate can increase. Interest caps come in two versions:

• A periodic adjustment cap, which limits the amount the interest rate can adjust up or down from one adjustment period to the next after the first adjustment, and
• A lifetime cap, which limits the interest-rate increase over the life of the loan. By law, virtually all ARMs must have a lifetime cap.

Periodic adjustment caps

Let's suppose you have an ARM with a periodic adjustment interest-rate cap of 2%. However, at the first adjustment, the index rate has risen 3%. The following example shows what happens.

Examples All examples on this website are based on a $200,000 loan amount and a 30-year term. Payment amounts in the examples do not include taxes, insurance, condominium or home-owner association fees, or similar items. These amounts can be a significant part of your monthly payment.

In this example, because of the cap on your loan, your monthly payment in year 2 is $138.70 per month lower than it would be without the cap, saving you $1,664.40 over the year.

Some ARMs allow a larger rate change at the first adjustment and then apply a periodic adjustment cap to all future adjustments.

A drop in interest rates does not always lead to a drop in your monthly payments. With some ARMs that have interest-rate caps, the cap may hold your rate and payment below what it would have been if the change in the index rate had been fully applied. The increase in the interest that was not imposed because of the rate cap might carry over to future rate adjustments. This is called carryover. So at the next adjustment date, your payment might increase even though the index rate has stayed the same or declined.

The following example shows how carryovers work. Suppose the index on your ARM increased 3% during the first year. Because this ARM limits rate increases to 2% at any one time, the rate is adjusted by only 2%, to 8% for the second year. However, the remaining 1% increase in the index carries over to the next time the lender can adjust rates. So when the lender adjusts the interest rate for the third year, even if there has been no change in the index during the second year, the rate still increases by 1%, to 9%.

In general, the rate on your loan can go up at any scheduled adjustment date when the lender's standard ARM rate (the index plus the margin) is higher than the rate you are paying before that adjustment.

Lifetime caps

The next example shows how a lifetime rate cap would affect your loan. Let's say that your ARM starts out with a 6% rate and the loan has a 6% lifetime cap--that is, the rate can never exceed 12%. Suppose the index rate increases 1% in each of the next 9 years. With a 6% overall cap, your payment would never exceed $1,998.84--compared with the $2,409.11 that it would have reached in the tenth year without a cap.

Payment caps

In addition to interest-rate caps, many ARMs--including payment-option ARMs--limit, or cap, the amount your monthly payment may increase at the time of each adjustment. For example, if your loan has a payment cap of 7½%, your monthly payment won't increase more than 7½% over your previous payment, even if interest rates rise more. For example, if your monthly payment in year 1 of your mortgage was $1,000, it could only go up to $1,075 in year 2 (7½% of $1,000 is an additional $75). Any interest you don't pay because of the payment cap will be added to the balance of your loan. A payment cap can limit the increase to your monthly payments but also can add to the amount you owe on the loan. (This is called negative amortization.)

Let's assume that your rate changes in the first year by 2 percentage points but your payments can increase no more than 7½% in any 1 year. The following graph shows what your monthly payments would look like.

While your monthly payment will be only $1,289.03 for the second year, the difference of $172.69 each month will be added to the balance of your loan and will lead to negative amortization.

Some ARMs with payment caps do not have periodic interest-rate caps. In addition, as explained below, most payment-option ARMs have a built-in recalculation period, usually every 5 years. At that point, your payment will be recalculated (lenders use the term recast) based on the remaining term of the loan. If you have a 30-year loan and you are at the end of year 5, your payment will be recalculated for the remaining 25 years. The payment cap does not apply to this adjustment. If your loan balance has increased, or if interest rates have risen faster than your payments, your payments could go up a lot.

Types of ARMs

Hybrid ARMs

Hybrid ARMs often are advertised as 3/1 or 5/1 ARMs--you might also see ads for 7/1 or 10/1 ARMs. These loans are a mix--or a hybrid--of a fixed-rate period and an adjustable-rate period. The interest rate is fixed for the first few years of these loans--for example, for 5 years in a 5/1 ARM. After that, the rate may adjust annually (the 1 in the 5/1 example), until the loan is paid off. In the case of 3/1 or 5/1 ARMs:

• the first number tells you how long the fixed interest-rate period will be, and
• the second number tells you how often the rate will adjust after the initial period.

You may also see ads for 2/28 or 3/27 ARMs--the first number tells you how many years the fixed interest-rate period will be, and the second number tells you the number of years the rates on the loan will be adjustable. Some 2/28 and 3/27 mortgages adjust every 6 months, not annually.

Interest-only (I-O) ARMs

An interest-only (I-O) ARM payment plan allows you to pay only the interest for a specified number of years, typically for 3 to 10 years. This allows you to have smaller monthly payments for a period. After that, your monthly payment will increase--even if interest rates stay the same--because you must start paying back the principal as well as the interest each month. For some I-O loans, the interest rate adjusts during the I-O period as well.

For example, if you take out a 30-year mortgage loan with a 5-year I-O payment period, you can pay only interest for 5 years and then you must pay both the principal and interest over the next 25 years. Because you begin to pay back the principal, your payments increase after year 5, even if the rate stays the same. Keep in mind that the longer the I-O period, the higher your monthly payments will be after the I-O period ends.

Payment-option ARMs

A payment-option ARM is an adjustable-rate mortgage that allows you to choose among several payment options each month. The options typically include the following:

• a traditional payment of principal and interest, which reduces the amount you owe on your mortgage. These payments are based on a set loan term, such as a 15-, 30-, or 40-year payment schedule.
• an interest-only payment, which pays the interest but does not reduce the amount you owe on your mortgage as you make your payments.
• a minimum (or limited) payment that may be less than the amount of interest due that month and may not reduce the amount you owe on your mortgage. If you choose this option, the amount of any interest you do not pay will be added to the principal of the loan, increasing the amount you owe and your future monthly payments, and increasing the amount of interest you will pay over the life of the loan. In addition, if you pay only the minimum payment in the last few years of the loan, you may owe a larger payment at the end of the loan term, called a balloon payment.

The interest rate on a payment-option ARM is typically very low for the first few months (for example, 2% for the first 1 to 3 months). After that, the interest rate usually rises to a rate closer to that of other mortgage loans. Your payments during the first year are based on the initial low rate, meaning that if you only make the minimum payment each month, it will not reduce the amount you owe and it may not cover the interest due. The unpaid interest is added to the amount you owe on the mortgage, and your loan balance increases. This is called negative amortization. This means that even after making many payments, you could owe more than you did at the beginning of the loan. Also, as interest rates go up, your payments are likely to go up.

Payment-option ARMs have a built-in recalculation period, usually every 5 years. At this point, your payment will be recalculated (lenders use the term recast) based on the remaining term of the loan. If you have a 30-year loan and you are at the end of year 5, your payment will be recalculated for the remaining 25 years. If your loan balance has increased because you have made only minimum payments, or if interest rates have risen faster than your payments, your payments will increase each time your loan is recast. At each recast, your new minimum payment will be a fully amortizing payment and any payment cap will not apply. This means that your monthly payment can increase a lot at each recast.

Lenders may recalculate your loan payments before the recast period if the amount of principal you owe grows beyond a set limit, say 110% or 125% of your original mortgage amount. For example, suppose you made only minimum payments on your $200,000 mortgage and had any unpaid interest added to your balance. If the balance grew to $250,000 (125% of $200,000), your lender would recalculate your payments so that you would pay off the loan over the remaining term. It is likely that your payments would go up substantially.

More information on interest-only and payment-option ARMs is available in a Federal Reserve Board brochure, Interest-Only Mortgage Payments and Payment-Option ARMs--Are They for You?

Consumer cautions

Discounted interest rates

Many lenders offer more than one type of ARM. Some lenders offer an ARM with an initial rate that is lower than their fully indexed ARM rate (that is, lower than the sum of the index plus the margin). Such rates--called discounted rates, start rates, or teaser rates--are often combined with large initial loan fees, sometimes called points, and with higher rates after the initial discounted rate expires.

Your lender or broker may offer you a choice of loans that may include "discount points" or a "discount fee." You may choose to pay these points or fees in return for a lower interest rate. But keep in mind that the lower interest rate may only last until the first adjustment.

If a lender offers you a loan with a discount rate, don't assume that means that the loan is a good one for you. You should carefully consider whether you will be able to afford higher payments in later years when the discount expires and the rate is adjusted.

Here is an example of how a discounted initial rate might work. Let's assume that the lender's fully indexed one-year ARM rate (index rate plus margin) is currently 6%; the monthly payment for the first year would be $1,199.10. But your lender is offering an ARM with a discounted initial rate of 4% for the first year. With the 4% rate, your first-year's monthly payment would be $954.83.

With a discounted ARM, your initial payment will probably remain at $954.83 for only a limited time--and any savings during the discount period may be offset by higher payments over the remaining life of the mortgage. If you are considering a discount ARM, be sure to compare future payments with those for a fully indexed ARM. In fact, if you buy a home or refinance using a deeply discounted initial rate, you run the risk of payment shock, negative amortization, or prepayment penalties or conversion fees.

Payment shock

Payment shock may occur if your mortgage payment rises sharply at a rate adjustment. Let's see what would happen in the second year if the rate on your discounted 4% ARM were to rise to the 6% fully indexed rate.

As the example shows, even if the index rate were to stay the same, your monthly payment would go up from $954.83 to $1,192.63 in the second year.

Suppose that the index rate increases 1% in one year and the ARM rate rises to 7%. Your payment in the second year would be $1,320.59.

That's an increase of $365.76 in your monthly payment. You can see what might happen if you choose an ARM because of a low initial rate without considering whether you will be able to afford future payments.

If you have an interest-only ARM, payment shock can also occur when the interest-only period ends. Or, if you have a payment-option ARM, payment shock can happen when the loan is recast.

The following example compares several different loans over the first 7 years of their terms; the payments shown are for years 1, 6, and 7 of the mortgage, assuming you make interest-only payments or minimum payments. The main point is that, depending on the terms and conditions of your mortgage and changes in interest rates, ARM payments can change quite a bit over the life of the loan--so while you could save money in the first few years of an ARM, you could also face much higher payments in the future.

Negative amortization--When you owe more money than you borrowed

Negative amortization means that the amount you owe increases even when you make all your required payments on time. It occurs whenever your monthly mortgage payments are not large enough to pay all of the interest due on your mortgage--meaning the unpaid interest is added to the principal on your mortgage, and you will owe more than you originally borrowed. This can happen because you are making only minimum payments on a payment-option mortgage or because your loan has a payment cap.

For example, suppose you have a $200,000, 30-year payment-option ARM with a 2% rate for the first 3 months and a 6% rate for the remaining 9 months of the year. Your minimum payment for the year is $739.24, as shown in the graph above. However, once the 6% rate is applied to your loan balance, you are no longer covering the interest costs. If you continue to make minimum payments on this loan, your loan balance at the end of the first year of your mortgage would be $201,118--or $1,118 more than you originally borrowed.

Because payment caps limit only the amount of payment increases, and not interest-rate increases, payments sometimes do not cover all the interest due on your loan. This means that the unpaid interest is automatically added to your debt, and interest may be charged on that amount. You might owe the lender more later in the loan term than you did at the beginning.

A payment cap limits the increase in your monthly payment by deferring some of the interest. Eventually, you would have to repay the higher remaining loan balance at the interest rate then in effect. When this happens, there may be a substantial increase in your monthly payment.

Some mortgages include a cap on negative amortization. The cap typically limits the total amount you can owe to 110% to 125% of the original loan amount. When you reach that point, the lender will set the monthly payment amounts to fully repay the loan over the remaining term. Your payment cap will not apply, and your payments could be substantially higher. You may limit negative amortization by voluntarily increasing your monthly payment.

Be sure you know whether the ARM you are considering can have negative amortization.

Home Prices, Home Equity, and ARMs Sometimes home prices rise rapidly, allowing people to quickly build equity in their homes. This can make some people think that even if the rate and payments on their ARM get too high, they can avoid those higher payments by refinancing their loan or, in the worst case, selling their home. It's important to remember that home prices do not always go up quickly--they may increase a little or remain the same, and sometimes they fall. If housing prices fall, your home may not be worth as much as you owe on the mortgage. Also, you may find it difficult to refinance your loan to get a lower monthly payment or rate. Even if home prices stay the same, if your loan lets you make minimum payments (see payment-option ARMs), you may owe your lender more on your mortgage than you could get from selling your home.

Prepayment penalties and conversion

If you get an ARM, you may decide later that you don't want to risk any increases in the interest rate and payment amount. When you are considering an ARM, ask for information about any extra fees you would have to pay if you pay off the loan early by refinancing or selling your home, and whether you would be able to convert your ARM to a fixed-rate mortgage.

Prepayment penalties

Some ARMs, including interest-only and payment-option ARMs, may require you to pay special fees or penalties if you refinance or pay off the ARM early (usually within the first 3 to 5 years of the loan). Some loans have hard prepayment penalties, meaning that you will pay an extra fee or penalty if you pay off the loan during the penalty period for any reason (because you refinance or sell your home, for example). Other loans have soft prepayment penalties, meaning that you will pay an extra fee or penalty only if you refinance the loan, but you will not pay a penalty if you sell your home. Also, some loans may have prepayment penalties even if you make only a partial prepayment.

Prepayment penalties can be several thousand dollars. For example, suppose you have a 3/1 ARM with an initial rate of 6%. At the end of year 2 you decide to refinance and pay off your original loan. At the time of refinancing, your balance is $194,936. If your loan has a prepayment penalty of 6 months' interest on the remaining balance, you would owe about $5,850.

Sometimes there is a trade-off between having a prepayment penalty and having lower origination fees or lower interest rates. The lender may be willing to reduce or eliminate a prepayment penalty based on the amount you pay in loan fees or on the interest rate in the loan contract.

If you have a hybrid ARM--such as a 2/28 or 3/27 ARM--be sure to compare the prepayment penalty period with the ARM's first adjustment period. For example, if you have a 2/28 ARM that has a rate and payment adjustment after the second year, but the prepayment penalty is in effect for the first 5 years of the loan, it may be costly to refinance when the first adjustment is made.

Most mortgages let you make additional principal payments with your monthly payment. In most cases, this is not considered prepayment, and there usually is no penalty for these extra amounts. Check with your lender to make sure there is no penalty if you think you might want to make this type of additional principal prepayment.

Conversion fees

Your agreement with the lender may include a clause that lets you convert the ARM to a fixed-rate mortgage at designated times. When you convert, the new rate is generally set using a formula given in your loan documents.

The interest rate or up-front fees may be somewhat higher for a convertible ARM. Also, a convertible ARM may require a fee at the time of conversion.

Graduated-payment or stepped-rate loans

Some fixed-rate loans start with one rate for 1 or 2 years and then change to another rate for the remaining term of the loan. While these are not ARMs, your payment will go up according to the terms of your contract. Talk with your lender or broker and read the information provided to you to make sure you understand when and by how much the payment will change.

Where to Get Information

Disclosures from lenders

You should receive information in writing about each ARM program you are interested in before you have paid a nonrefundable fee. It is important that you read this information and ask the lender or broker about anything you don't understand--index rates, margins, caps, and other ARM features such as negative amortization. After you have applied for a loan, you will get more information from the lender about your loan, including the APR, a payment schedule, and whether the loan has a prepayment penalty.

The APR is the cost of your credit as a yearly rate. It takes into account interest, points paid on the loan, any fees paid to the lender for making the loan, and any mortgage insurance premiums you may have to pay. You can compare APRs on similar ARMs (for example, compare APRs on a 5/1 and a 3/1 ARM) to determine which loan will cost you less in the long term, but you should keep in mind that because the interest rate for an ARM can change, APRs on ARMs cannot be compared directly to APRs for fixed-rate mortgages.

You may want to talk with financial advisers, housing counselors, and other trusted advisers. Contact a local housing counseling agency, call the U.S. Department of Housing and Urban Development toll-free at 800-569-4287, or visit online to find a center near you.

Newspapers and the Internet

When buying a home or refinancing your existing mortgage, remember to shop around. Compare costs and terms, and negotiate for the best deal. Your local newspaper and the Internet are good places to start shopping for a loan. You can usually find information on interest rates and points for several lenders. Since rates and points can change daily, you'll want to check information sources often when shopping for a home loan.

The Mortgage Shopping Worksheet may also help you. Take it with you when you speak to each lender or broker and write down the information you obtain. Don't be afraid to make lenders and brokers compete with each other for your business by letting them know that you are shopping for the best deal.

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Any initial information you receive about mortgages probably will come from advertisements or mail solicitations from builders, real estate brokers, mortgage brokers, and lenders. Although this information can be helpful, keep in mind that these are marketing materials--the ads and mailings are designed to make the mortgage look as attractive as possible. These ads may play up low initial interest rates and monthly payments, without emphasizing that those rates and payments could increase substantially later. So, get all the facts.

Any ad for an ARM that shows an initial interest rate should also show how long the rate is in effect and the APR on the loan. If the APR is much higher than the initial rate, your payments may increase a lot after the introductory period, even if interest rates stay the same.

Choosing a mortgage may be the most important financial decision you will make. You are entitled to have all the information you need to make the right decision. Don't hesitate to ask questions about ARM features when you talk to lenders, mortgage brokers, real estate agents, sellers, and your attorney, and keep asking until you get clear and complete answers.

Mortgage points are an important part of any home purchase. But if you have never purchased a home before, you may not know what the different types of points are and what they can mean for you. Here is a brief discussion of points and information you should know so you can make the best educated decision about your finances when buying a home.

Origination Points

An origination point is the term that refers to the fees that your lender receives during the loan origination process. The fee is for the work that they do for you by evaluating your credit worthiness, processing the paperwork and approving your loan.

Generally, one origination point is equal to one percent of the mortgage loan. For instance, if you are paying two origination points to your lender and your loan is for $100,000, you would be paying $2,000 to your lender to compensate them for the work that they are doing for you. When going through the mortgage borrowing process, ask about negotiating the origination points and you may be able to pay less money to your lender at closing.

Since every individual lender is different, it is possible that you might find one that does not even charge origination points. However, if you find a lender that advertises no origination points, it is possible that they have other hidden fees and charges that make up for that. That’s why it is so important to have a trusted advisor look at your loan documents before you agree to something you do not understand. You could end up paying thousands more over the term of the loan if you make the wrong decision.

Discount Points

Discount points are designed for buyers who want to pay lower mortgage rates for the entire term of the loan in return for paying an additional fee up front. In general, if you purchase one Discount Point, you could lower your fixed interest rate by as much as a quarter of a percentage point. For an adjustable rate mortgage, you can lower your mortgage rate by as much as 0.375 percent. Your particular lender may even allow more flexibility in the amount of the buydown so you may get an even bigger discount in some cases.

As an example, if you qualify for a mortgage rate of 5 percent and you buy 2 Discount Points, you could reduce your interest rate by as much as 0.75 percent so your new rate would be 4.25 percent. Each Discount Point typically costs the equivalent of one percent of the total loan value. This means that if your mortgage loan is $100,000, each Discount Point would cost you $1,000. So in order to reduce your interest rate by 2 points on a $100,000 loan, you would have to pay $2,000 up front.

One of the benefits of paying Discount Points is that you may be eligible for a tax deduction if you itemize on your yearly tax forms. Schedule A of your 1040 IRS tax returns should have a section where you can enter the amount of Discount Points you purchased, but it is always best to work with a tax advisor or financial consultant when determining the amount of deductions you can legally take.

When shopping for a mortgage, there are several types of mortgages to choose from. However, there are two main types that you should consider – either a fixed rate mortgage or an adjustable rate mortgage, or ARM. Both of them have their advantages. If you always thought an ARM was not a good idea, here are some advantages that you may not have known about.

• You may benefit from an ARM if your future plans are to stay in the home for only a short period.

Could your employer transfer you to another state in the near future? Do you plan on having kids in the next few years and moving to a larger home? If you choose an ARM for your mortgage, your monthly payments will ordinarily be on a 30 year amortization schedule and your rate will likely be slightly lower than the 30 year rate. Therefore, your monthly payments will be lower than a standard 15 or 30 year mortgage.

• The overall index helps determine your rate.

There is the risk of increasing interest rates if you take out an ARM and hold it for longer than the fixed term (usually five years). Part of the amount of the adjustment in your interest rate is determined mainly by the overall market conditions. If interest rates rise, the reference rate in your mortgage will likely rise as well. You should know what the reference rate is in your mortgage (Treasury rate, LIBOR rate, etc.). Your lender cannot typically raise your rate without an appropriate move in that reference rate. Also, every ARM has a maximum amount that it can change yearly (periodic cap) and a total cap, meaning that the interest rate can only go so high in each year and during the term of the loan.

• No need to worry about refinancing if rates decline.

One thing that many homeowners with adjustable rate mortgages enjoy is the fact that they don’t have to worry about refinancing when mortgage rates go down. Since the adjustable rates automatically adjust with the current market conditions, there is no need to go through the hassle and costs of refinancing to get a lower rate. Your monthly payments will reflect the lower rate which can save you money.

These are just a few benefits you can expect to have when you choose an adjustable rate mortgage. If you are trying to decide which one is right for you, consult with a trained and trusted financial advisor to learn more about each one so you can make an informed decision.