Question: We are thinking of taking out a 3/1 adjustable rate mortgage in the amount of $275,000 at 4.25 percent. The APR is 4.57 percent. We would be paying 2.50 points and rolling them into the loan.

It is my understanding that after the 3rd year, the rate will adjust to 4.57 percent over the full 30 years or up to 6.25 percent depending on market. I am under the assumption that this a good deal. However, my husband says that even if we pay the points, we may have to refinance in three years. I thought it was a good deal. Where can you find a simple term explanation of how the 3/1 actually breaks down (amortization) after the third year?

Answer: Your question is a perfect example of why it's important to have a good loan officer to help you through the mortgage process. There are hundreds of different mortgage programs available, and unless you are quite familiar with the business, you're going to need someone to help you choose and understand the appropriate product. Let's take a step back and dissect your e-mail.

A 3/1 ARM is a mortgage with a 30 year term. The initial interest rate is fixed for the first three years, and then it adjusts annually for the remaining 27 years. At the end of the third year, the rate will adjust based upon a predetermined index and margin. The index is the rate that the mortgage program follows at the time of adjustment. A common index is the One Year Treasury Yield. The margin is the predetermined amount that is added to the index to determine the new mortgage rate.

For example, after three years, the One Year T-bill might be carrying a rate of 3.75 percent. The predetermined margin on the loan is 2.75 percent. To find out your rate in year four, we simply add the index and margin together. In this example, your rate would jump to 6.50 percent.

Most ARMs have annual and lifetime "caps", which prevent the rate from going too high. Typically, you'll see two percent annual caps and a six percent lifetime cap. This means that the rate cannot increase by more than two percent each year and not exceed six percent over the start rate, or 10.25 percent (4.25% + 6.00%), for the life of the loan.

Now let me address some things in your e-mail. Your husband says that you may have to refinance in three years, even if you pay points. First, the only way you would be forced to refinance, is if the mortgage program carries a "balloon" feature. This means the lender requires that the loan be paid in full within a specified period of time. Loans that balloon in three years are rare. The most common types of balloon loans are the so-called "two-step" programs, which carry a fixed rate for five or seven years and balloon at the end of the fixed rate term. Called 5/25's or 7/23's, they usually give the borrower an option to convert the loan to a fixed market rate instead of paying it off.

So I'm pretty sure your husband is incorrect about being required to refinance. And whether or not you pay points would have nothing to do with a balloon feature -- one has nothing to do with the other.

Now let's talk about points. In one word: DON'T. Two and a half points on a $275,000 loan equates to $6,875 in non-refundable fees. If you don't pay the points out of pocket, your loan balance increases to $281,875. You lose nearly $7,000 in equity.

It never makes sense to pay points on a short term adjustable rate. Remember that paying points "buys down" the interest rate. If the interest rate that you're buying down is only good for three years, you can make a safe bet that you won't recoup the costs of the points before the rate can jump up.

I'm looking at today's and if you have good credit and a qualifying income, 4.25 percent on a 3/1 ARM with 2.50 points is a rotten deal. A rate with zero points might be close to five percent. By taking the lower, more expensive rate, your payment drops by only $89 per month for the next three years. Even if I ignore the tax advantage of taking the higher interest rate, I see that it would take nearly six and a half years to recoup your points -- far longer than your guaranteed three year rate.

The last thing I want to talk about very quickly is the APR, or Annual Percentage Rate. The APR is designed to give the consumer an idea of your total borrowing costs after taking into consideration the costs associated with obtaining the loan. The problem is that the APR uses some incorrect assumptions when it determines costs. When taking out an ARM, an APR is even more useless because the rate can adjust in the future so there's no way of knowing an ARM's true APR. The guy that gave you an APR of 4.57 percent is surely making an assumption that your rate will drop in three years. Using my computer to calculate your APR, with the assumption that rates will remain the same in three years, I come up with 5.93 percent. The points are killing you.

My advice would be to seek out recommendations from trusted advisors (family, friends, co-workers) who might be able to point you towards an experienced and competent loan officer. He/she will be able to give you good advice.

Published: April 14, 2005

Use of this article without permission is a violation of federal copyright laws.

, the president of PMC Mortgage Corporation in Alexandria, VA, is a mortgage columnist whose work has appeared in numerous consumer, real estate, and mortgage publications. Mr. Savage welcomes your questions for possible use in this column, however because of the volume of mail received, Mr. Savage cannot answer questions individually.