OK, a confession here. The title of this blog post was meant to grab attention. Certainly there is no intent to imply that homebuyers that choose an adjustable rate mortgage fall into the same category as our wayward friend, Walter White. That said, during the financial collapse of 2008, ARM loans were cast into the fire and vilified as one of the elements that contributed to the collapse. Truthfully during that time, the fact that a mortgage was an ARM wasn’t typically the primary problem. Subprime loans, & loans that did not verify income were often written as ARM loans, & the combination would sometimes create a true perfect storm. ARM loans are now regaining favor with some buyers as interest rates have recently increased. This is certainly a relative statement, as rates remain very low & attractive compared to historic mortgage rates.
Adjustable Rate Loan Types
Adjustable rates come in a variety of configurations. However, there are fewer choices today as lenders modify their “menu” to meet the new “qualified mortgage (QM)” regulatory requirements, as discussed in earlier posts. Much of the QM focus has been on the “ability to repay” requirements, and how that might affect homebuyers. There are additional QM provisions which prohibit “loans with risky features”. Some of the “risky” loans that got folks in trouble in the past were loans that incorporated interest only features, negative amortization, or terms greater than 30 years. Today, most lenders offer what is called “hybrid ARM” loans, in which the interest rate is fixed for a period of time, usually 3, 5, 7, or 10 years. After this “fixed rate” period, the loan will adjust annually, within predetermined limits or “caps”.
Advantages & Disadvantages
The primary advantage of an ARM loan is that the interest rate starts out measurably lower than a fixed rate loan (see chart below). The difference between these rates is not constant, and this becomes an important element in deciding if the risk is offset by sufficient reward. In other words, is the rate “spread” between a fixed rate loan & an adjustable rate loan sufficient to compensate for the risk of what may happen when the loan starts to adjust. The primary disadvantage of an ARM loan is that chronic inability to predict the future. If a homebuyer feels that he must use an ARM loan to make his home affordable, & then relies on a future event to avoid the adjustment phase, he is taking a tremendous risk. If the recent recession taught us anything, it is that there are no guarantees. No guarantee that one will be able to sell a home without being upside down, no guaranty of employment or income stability, no guaranty of being able to refinance at a specific time to get out of an ARM.
Who Can Safely Benefit from an ARM Loan?
“Safely benefit” is a bit of a loaded question. Everyone’s financial situation & risk tolerance is different. But here are some questions to ask to determine if an ARM loan is right for you:
- Do you have a clear understanding of the “loan mechanics”; knowing when your loan will adjust, what the limits or caps are, & what “index” & “margin” is the loan tied to. This will determine what an adjusted rate will be when the time comes.
- Is there a predetermined financial event that might permit you to pay off (or pay down) your ARM loan? One can mitigate risk if the ARM loan never reaches the adjustment period.
- Are you in a very conservative financial position? Buying well below one’s qualifying limit & routinely having solid cash reserves can also help “weather a storm” if interest rates rise.
- What is the difference in rate between an ARM loan & a fixed rate loan. If the savings is a whopping 1/4 of a percent, is the risk justified?
When shopping for a mortgage loan, never let your loan officer determine the loan that is “best for you”. Only you can make that decision. A good loan officer will give you all of the important particulars for your given loan choices, & will explain the relevant plusses & minuses. Once you have ALL the facts, make the decision that is best for you. Sometimes, you need to set the numbers aside & ask “can I sleep at night with the choice that I made?” Now go find that dream home. It’s a great time to be a buyer!
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