Q: We want to get pre-approved for a mortgage to buy our first home, but we're confused by all the different loan programs available.  We don't know whether we should go with a fixed-rate loan or an Adjustable Rate Mortgage (ARM).  And if we go with an ARM, how important is the index?  We've heard about the "COFI" index, the "LIBOR" index and the "One Year T-Bill" index.  What's the difference between these indexes, and which one is better? 

A: The vast array of mortgage programs available today can be overwhelming, especially to first time home buyers.  It's difficult for those of us who work full time in the mortgage industry to keep up with the latest loan programs, let alone home buyers trying to find their way through the jungle of rates and terms.

First, the question of whether to go with a fixed or adjustable rate (ARM) loan depends on two factors: 1) How long do you intend to keep the property?  2) What is your personal level of "risk tolerance?"

In general, an ARM is a good way to go if you intend to sell the home and trade up in a few years.  That's because ARM interest rates are lower than 30-year fixed rate loans.  However, because of the current "inverted yield curve" in the financial markets, short-term rates are almost as high as long-term interest rates, so the spread between fixed rates and ARM rates is not as wide as it used to be. Still, the lower interest rate on an ARM may make the difference between qualifying for the loan amount you want versus accepting a smaller loan amount on a fixed rate loan.  

The longer you plan to hold the loan, the more sense it makes to consider a 30-year fixed rate loan.  Note that I said "consider."  It's not a forgone conclusion that a fixed rate loan is a better deal over the long haul -- it just eliminates the uncertainty about the amount of your mortgage payments in the future.  That's why you need to know your risk tolerance level.  The interest rate on 30-year fixed rate loans has risen almost two percentage points from low point in 1998.  If you believe mortgage rates will be dropping again in the near future, you may want to take a chance on an ARM loan.  However, if you'll be lying awake at night worrying about your next interest rate adjustment, it's not worth it.  As I've said before in this column, peace of mind is just as valid a consideration  in setting your financial goals as rate of return.

Borrowers who want the low interest rate of an ARM but the stability of a fixed rate loan can have it both ways with so-called "hybrid" ARM's that are fixed for periods of three-, five-,  or seven-years, before becoming adjustable.  The longer the initial fixed period, the higher the interest rate.  For example, ARM's with an initial fixed period of one year or less are currently available with starting rates as low as 6.25 percent. ARM's fixed for the first three years start at about 6.875 percent and five-year ARM's start at about 7.125 percent.  This compares to today's 30-year fixed rate loans of about 7.625 percent.  All of the above rates assume a loan fee of approximately two "points" 2 percent of loan amount)  If you pay fewer points at closing, you will get a higher interest rate.   

Once you've decided to go with an ARM loan, you need to be aware of two important numbers:  1) The index.  2) The margin.  The index is a floating financial market measure.  The margin is a fixed number that is added to the index to determine your interest rate.  For example an index of 6 percent plus a margin of 2.75 percent would equal an interest rate of 8.75 percent.  That is the "real" or fully indexed rate of your loan.  However, ARM's typically start out with low "teaser" rates that are one to three percent below the fully-indexed rate. 

There are several different ARM indices used today.  Among the most common are the "One Year T-Bill" index, which is based on the average yield on One-Year U.S. Treasury Bills.  This week, the T-Bill index is 6.30 percent.  Another common ARM index is the London Interbank Offered Rate, commonly called "LIBOR."  This is an international money rate.  The LIBOR index this week is 6.53 percent.  Another index that you mentioned is the "11th District Cost of Funds Index," commonly called "COFI."  This is the average interest rate that banks in the 11th district of the Federal Reserve (West Coast) pay for the funds they lend out.  The COFI index is currently 4.967 percent.  One advantage of the COFI index is that it is much less volatile than those other two indices.   

Using the current indices above, if you add a typical margin of 2.75 percent to the three ARM indices you get "real" interest rates of 9.05 percent for a T-Bill ARM, 9.28 percent for a LIBOR ARM and 7.717 percent for a COFI ARM.  Which ARM would you choose?  Don't be dazzled by the low "teaser" rate, look at the real rate you'll get when your ARM is fully-indexed.

Does this mean COFI ARM's are good and T-Bill ARM's are bad?  Not necessarily.  There are instances where a T-Bill ARM might be the best option for a borrower.  For example, it may allow the borrower to qualify at the low starting rate, which enables the home buyer to get a larger loan for a given amount of income.  

The correct answer to the home mortgage equation depends on the needs, desires and qualifying ability of the individual borrower.  There are many different mortgage programs available today because there are many different types of home buyers.  Rather than shopping rates and terms, shop for a knowledgeable loan officer.  He or she will then help you select the loan program that's best for you.

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