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August 10, 2004

Is an ARM, Adjustable Rate Mortgage, Appropriate Now?

With mortgage rates at such low levels, the general consensus is that rates are more likely to go up rather than down. Based on that fact, does it make sense to even consider an Adjustable Rate Mortgage (ARM) now? P>The answer depends on how long you plan to live in your home and the rate differential between fixed and adjustable rate mortgages. While most homeowners opt for 30-year fixed mortgages, most mortgages aren't held nearly that long. According to Freddie Mac, the average life of a 30-year mortgage is five years, with the mortgage being refinanced or paid off due to a home sale (Source: Kiplinger's Personal Finance, May 2004). The ARM's lower interest rate may make it a good alternative if you plan to move in a short period of time or are willing to take the risk that rates will increase later for lower mortgage payments now.

You can obtain an ARM with an interest rate that is fixed for one year, five years, or 10 years, which adjusts periodically after that initial period. Compared to a 30-year fixed mortgage, a one-year ARM is typically 2% lower, a five-year ARM is 1% lower, and a 10-year ARM is slightly lower. Before obtaining an ARM, consider these factors:

  • The initial interest rate. Make sure you understand how long the rate is effective, especially if it is a teaser rate.

  • The index used for rate adjustments. The two most common indexes used are the One-Year Treasury Constant Maturity Series and the 11th District Cost-of-Funds Index. While both indexes have averaged approximately the same, the Cost-of-Funds Index tends to be less volatile, which could be good in an environment of rising interest rates.

  • The period between adjustments. Find out how frequently the interest rate will be adjusted. Options include monthly, every six months, and annually. Less frequent adjustments mean your mortgage payment will not change for a longer period.

  • Interest-rate caps. Determine how much the first adjustment can increase (typically capped at 1% to 5% over the initial rate), subsequent increases (typically 1% to 2%), and the maximum increase over the loan's life (typically no more than 5% to 6% over the initial rate). Then calculate how your mortgage payment would change in the worst-case scenario.

Setting Your Financial Goals

Properly designed, your financial goals should provide the motivation you need to control your spending. Often, individuals develop vague goals such as paying for a child's college education, getting out of debt, or retiring comfortably. Since the goals are vague, they don't provide help in deciding how to accomplish them or in determining whether you are making sufficient progress toward achieving them. Keep these tips in mind when developing financial goals:
  • Set exciting goals. Your goals should keep you motivated to reduce spending and save for the future. For instance, instead of "saving for retirement," a specific goal would be "retiring at age 60 with $1,000,000 in investments so you can travel and golf." Whenever you're tempted to abandon that goal, visualize what you're saving for.

  • Make your goals meaningful to you. Everyone knows they should be saving for retirement, but if you think you're too young to worry about that, set another goal that is relevant to you now. When you are getting started, setting goals you're motivated to achieve will help you realize the importance of the goal-setting process. Once you achieve some short-term goals, you may become more motivated to set longer term goals.

  • State your goals in measurable terms. Quantify your ultimate goals as well as interim goals so you can track your progress. If you need $500,000 in 20 years, how much should you have after one year, five years, or 10 years?

  • Prioritize your goals. If you have more than one goal, you may not have the resources to achieve all of them at the same time. Prioritize your goals so you work toward those most important to you.

  • Don't be afraid to set ambitious goals. Just because a goal is difficult to achieve doesn't mean you should not strive to achieve it. It does mean you'll have to develop appropriate strategies and stay disciplined.

  • Reward yourself when you make progress toward your goals. To maintain your commitment to goals that can take years to achieve, reward yourself when you reach interim goals.

After setting goals, you'll need strategies to achieve those goals and a way to measure your progress. While that can require significant effort, significant payoffs are also involved. In a recent survey, 48% of respondents who were working toward their goals were very happy with their lives, compared to 30% of those just starting to work on goals and only 18% of those who didn't have goals (Source: Money, November 2003).

Do You Have a Spending Budget?

A budget serves as a road map for your spending,
helping you find ways to save more money for your financial goals.
Inefficient and wasted expenditures can be major impediments to
accomplishing your financial goals. For a one-month period, keep
track of every dollar you spend, whether by cash, check, or credit
card. Are you surprised by how much small expenditures add up
over a month?

To make sure you get the maximum benefit
from the budgeting process, keep these points in mind:

  • Use spending categories that make sense
    for your spending patterns. If there are areas with good potential
    for spending reductions, even if the amounts are relatively small,
    set them up in their own categories.

  • Set up enough categories to give you a
    good feel for your spending patterns, but not so many that it
    becomes difficult and time consuming to monitor your progress.

  • Include non-recurring items in your budget,
    such as gifts, tuition, insurance premiums, property taxes, etc.

  • Periodically compare your actual expenditures
    to your budgeted expenditures to find out where you are having

  • While everyone in the family should have
    some cash that can be spent without accounting for it, don't
    make the amount so large that it detracts from your savings efforts.

  • Include savings in your budget and make
    sure you actually save that amount every month.

  • While at times a budget may not seem worth
    the effort, remember that it is a tool to help you accomplish
    your financial goals. Remain committed and stick with it.

Teaching Money Lessons to Your Children

One of the most valuable lessons parents can teach their children is how to responsibly manage money. Some strategies to teach these lessons include:

Pay your children a weekly allowance, so they learn to budget money. Some people feel tying an allowance to performing chores instills the concept of working for pay, while others feel chores should be performed without pay as part of the child's family responsibilities. The allowance should increase with age, but should be large enough so children have money left over to make their own purchasing decisions. As much as possible, let your children spend the money as they wish, but don't bail them out when poor choices are made. Let them live with the consequences, so they aren't tempted to repeat their mistakes. That doesn't mean you can't discuss options or encourage them to make other choices, but the final decision should be theirs.

Give your children opportunities to earn extra money, so they learn that extra effort results in rewards. This gives them an opportunity to earn money for special purchases, while teaching them the rewards of good work ethics. As your children get older, they may want to take on part-time jobs for extra cash. While the jobs can offer good experience, they should realize that doing well in school is their primary responsibility. Go over your children's pay stubs with them, making sure they understand what taxes are deducted for and how much of their pay it represents.

Encourage your children to save, so they make saving a habit. It's usually easier to save if your child has a specific goal in mind, such as a new toy or bike. Many children will need incentives to encourage them to save. You can require a certain percentage of their weekly allowance be set aside for long-term savings goals. Or you can match your child's savings, perhaps contributing 50ยข for every dollar he/she saves.

Teach your children the basics of investing, so they learn how to make their savings grow. At an early age, help your child open a savings account. Use the bank statement as an opportunity to explain the concept of compound interest. As your children grow, start to expose them to other investment alternatives. Around age eight or so, explain how businesses operate and how investors buy and sell stocks. Ask for their input on which businesses would make good stock investments, then help them research those choices. They may want to use some of their savings to purchase those stocks. Teach them how to follow stock prices and how to review annual reports. Let your children decide when to buy and sell the stock.
Keep in mind that how you treat money is probably the most significant influence on your children. If you make large purchases only after careful research and price comparisons, your children will learn to be careful before making a purchase. If you use credit cards cautiously and explain how to select a card, what items to charge, and how to pay off the balance every month, your children will learn not to abuse credit cards.

Protecting Your Financial Assets

In light of recent global events, the world certainly seems like a more dangerous place, threatening your sense of personal safety and well-being. While there may not be much we can do on an individual level to reduce the threat of terrorism, war, or even stock market corrections, we can ensure that we take all appropriate steps to mitigate those risks under our control. If you're looking for ways to increase your financial security, consider the following tips:

  • Get your estate in order. While dealing with your own mortality is often difficult, it is one of the most important things you can do to help your family in the event of your death. Make sure your will reflects your current desires for the disposition of your assets and names a guardian for minor children. You should also consider a durable power of attorney, which designates someone to control your financial affairs if you become incapacitated, and a health care proxy, which delegates health care decisions when you are unable to make those decisions.

  • Review your portfolio. After the recent market declines, you may be inclined to lean toward
    a "safe" portfolio, i.e., one that doesn't contain stocks. But if you're saving for goals that are decades away,
    stocks probably should continue to hold a major position in your portfolio. The lesson we should learn from the recent market declines is that our portfolios should be diversified. A properly diversified portfolio will help protect its value during market declines, while still offering higher return potential.

  • Take another look at your life insurance. You need to purchase an appropriate amount of insurance to protect your family in the event of your death. The amount needed will depend on your current net worth, the lifestyle you want to provide for your family, and your personal circumstances and desires. Since your insurance needs will change over time, assess your insurance coverage periodically.

  • Obtain sufficient disability insurance. You should consider disability insurance if your current assets won't support you until age 65. Many companies provide short-term disability insurance which covers 100% of your salary for three to six months. Long-term disability insurance is typically less common and less generous. Thus, even if you have long-term disability insurance at work, you may want to obtain additional coverage. Your available resources and disability benefits should equal at least 60% of your pre-tax salary.

  • Make sure you have an emergency cash reserve. Consider setting aside at least three to six months of living expenses, although the exact amount will depend on your age, health, job outlook, and borrowing capacity.
    This can help in case of a job layoff, short-term disability, or large unexpected expenditure.

  • Consider long-term-care insurance. If your assets, not including your home, equal at least $1.5 to $2 million, you can probably fund long-term-care costs with those assets. Those with very few assets will probably
    be covered by Medicaid. It is the people between those two extremes who should consider long-term-care insurance. This coverage may be especially important for women, who tend to outlive their husbands. You should probably purchase the insurance while you are in your 50s or 60s. After that, the premiums get much more expensive. Also, if you develop a serious health condition, you may not be able to purchase the insurance.

  • Protect your financial identity. While you typically won't have to pay for anything charged by an identity thief, you will have to work to restore your credit and to ensure all fraudulent accounts are closed.
    That can be time consuming as well as expensive. To help protect your financial identity, only give out your Social Security number when it is required, shred documents, cut up old credit cards, and review your credit reports periodically.

  • Keep your homeowners insurance up to date. Review your homeowners policy carefully so you understand what would happen if your home was totally destroyed. It is your responsibility to make sure you have adequate policy limits, so inform your insurance company when you make major improvements, get an inflation
    rider for your policy, and make sure your policy covers the total cost of rebuilding your home.

  • Protect your home. There's nothing paranoid about obtaining a good home security system
    for your house, but make sure you use it after installation. Make sure all doors are metal or solid wood with deadbolt locks, use bars or locks to secure sliding glass doors, and keep all entrances well lit.

  • Properly store important documents. Documents that you might need when the bank is closed, such as passports, wills, or insurance policies, can be kept in a fireproof home safe. Other documents, such as deeds,
    stock certificates, and titles, should be kept at a safe deposit box in a bank.

  • Drive cautiously. One of the greatest daily risks we face is an automobile accident. So drive cautiously, always wear a seatbelt, purchase a car with good safety ratings, and get all-wheel drive or winter tires
    if you live in a snowy climate.


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