ARM loans – not as scary as it seems….
As mortgage brokers, we see it all the time – borrowers asking for the 30-year fixed because it’s exactly that…. fixed. It doesn’t change. The rate stays the same and the monthly payment stays the same for the entire 30-year term. It sounds comforting and safe because nothing can change and who wants to bother with reading fine print for those ‘exotic’ loans that can change and change for the worse.
Some common remarks:
“We like the fact that I don’t have to think about it”
“I like the certainty”
“I like the less risky strategy”
“wasn’t it because of these ARM loan products that caused the financial crisis from ten years ago anyway? “
No, sorry to disappoint you, they were not. The “Hybrid-ARM” loan had nothing to do with the downfall of Lehman Brothers, WaMu, Countrywide or World Savings. But that story is for another day. The point is that they are here to stay so borrowers should not prematurely dismiss them as a risky product.
It’s important to do a deep dive into ARM programs because most borrowers will fight tooth and nail to find the lowest 30-year fixed rate only to find out later that they were in the wrong loan program, to begin with. The 30-year fixed is definitely not a ‘risk-less’ choice – the only thing you guarantee is that you are paying the highest interest rate upon rate lock. As a borrower, you owe it to yourself to consider and learn the finer points of the hybrid-ARM loan before making an educated decision.
Here are some common questions we receive:
Q: How does it work?
A: The term is 30-years and the payments and interest rate are fixed from the outset – just like a 30-year fixed. However, this only lasts for an initial period – most frequently 5 or 7 years. Assuming the loan has not been paid off through a sale or refinance, the loan will then automatically adjust to a new rate and payment in the first month following the initial period.
Q: How does the rate adjust?
At the first change date, the new rate will be the sum of a given market index at that time, plus a fixed margin. Assume a common market index – the 1-year Libor, currently 2.71%, add it to the pre-determined margin of 2.50% (between 2.25 and 2.75% is industry standard) and your new rate will be 5.21%. Lenders usually round it to the nearest 1/8th percent. The rate stays the same for another 12 payments before adjusting again, year over year.
Q: What will my new payment become?
With the new rate, a new monthly payment is computed based on the number of years remaining on the 30-year term. For example, assume a 7/1 Libor-index ARM loan with an initial rate of 3.50%. At the beginning of the 8th year, the rate adjusts to the 1-year Libor index at that time, plus a margin of 2.25%, and then amortized over the final 23 years. At the beginning of the 9th year, the rate adjusts again, and is amortized over 22 years, and so on and so forth.
Q: ARMs make me nervous – what is the worst case scenario?
A common fear is that interest rates may skyrocket at the first change date. Upon further thought, however, that fear should be mitigated by micro and macro-economic factors. First, these programs have limits, or “CAPS” that limit the adjusted rate. This includes an initial CAP, a lifetime CAP and year-to-year cap. Furthermore, if interest rates actually do skyrocket, the economic cause and effect is such that other market factors occurring in a rising interest rate environment will offset the effect of a higher mortgage payment. Inflation will have most likely caused elevated wages and prices (including home values). Savings rates and dividends will increase, helping to absorb payment shock.
Remember that when comparing ARMs to a fixed program, it is important to realize the guaranteed savings you have with the ARM over the initial fixed period. The benefit of the 30-year, on the other hand, is realized over a much longer period – a period that, unfortunately, many people won’t ever reach. One, there is always a possibility to refinance to the same or lower rates. And two, while the uncertainty about length of ownership drives borrowers to the fixed products, the statistics show the average length of homeownership (not life of the loan, which is shorter) is still less than 10-years. So why pay a premium for a 30-year rate when you’ll only be there 10, on average?
For further discussion on ARM vs Fixed, please consult your favorite mortgage broker!