The ARM is back: Should you bite?

Adjustable-rate mortgages are rising in popularity again. Lenders say they have learned from their mistakes of the past decade, but have borrowers?

By doubleace Mar 21, 2011 12:36PM

This post comes from Lynn Mucken at MSN Money.

 

Adjustable-rate mortgages are making a comeback. It's official; after all, the news appeared in The New York Times.

 

You remember ARMs, don't you? They were the sweet sirens of the last couple of decades, luring Americans into the homebuying or refinance market with low initial interest rates and unspoken but hinted-at guarantees that nothing could go wrong.

 

Of course, things did go wrong -- terribly so -- when the real estate market imploded in 2006. ARMs weren't solely to blame for the real estate pyramid scheme whose collapse still haunts our struggling economy, but they did their part.Post continues after video.

Now ARMs are back -- up to 10% of all mortgages issued, double last year but still far from the 70% in 1994. So the questions once again are: Are they safe? Are they right for you? The answers are: Maybe, and maybe.

An adjustable-rate mortgage is a relatively simple lending device: The borrower gets the money to buy or refinance a home at a lower interest rate than is available through the traditional 30-year mortgage. That means lower house payments that you can afford now. Somewhere up the road -- six months, five years, seven years, whatever is specified in the contract -- the interest rate begins to adjust up or down according to a set formula based on interest-rate indexes.

 

It usually goes up -- inflation is almost always with us -- but in theory the borrower's income and home value have at least kept stride, so you can make the bigger payments or sell the house. The alleged safety net is that, if you are like most Americans, you will have sold your home and moved long before the higher interest kicks in, or you can easily slip into a less-volatile 30-year loan.

Unfortunately, it didn't work like that in 2006 and the unhappy years that followed. Too many loans had been granted to people -- the infamous subprime borrowers -- who bought too much house, were overextended even by the opening monthly payment or fell for lending gimmicks that allowed them to pay a "minimum" amount that actually increased their debt on the home. It's an old credit card trick, but when it is used on a $500,000 loan instead of an $800 bill, it is deadly.

Such people lost their homes, which helped collapse the housing market, which in turn destroyed the home value of even prime borrowers, who had no trouble paying their mortgage but couldn't sell their home because they owed more than it was worth on the market.

 

Lenders say that won't happen again.

 

They insist they won't lend to questionable borrowers. "An adjustable now is basically a prime product," Michael Moskowitz, the president of Equity Now, told The New York Times.

 

In addition, they say that the six-month rate change and high interest caps have mostly been replaced by relatively staid 5/1 or 7/1 ARMs (five or seven years at the initial interest rate, followed by annual changes in interest) with a maximum eventual cap 6 percentage points above the initial rate.

 

The savings available through ARMs are undeniable. Sean Bowler, a loan officer at DRB Mortgage, told the Times that someone borrowing $500,000 with a 5/1 ARM at 3.5% would save $42,507 in the first five years, before it adjusts, compared with a 30-year fixed-rate loan of 5.25%. A 7/1 ARM at 4.125% would save $38,330 over the first seven years.

 

So, should you go for an ARM?


Yes, bring it on.

  • If you have a large down payment that virtually ensures that you will still have equity in the home when the ARM begins to adjust upward.
  • If you are reasonably sure you will be selling the home before the interest rate starts climbing. This works especially well if you are 60 and plan to retire, and move, at 65.
  • If you have enough in savings to weather a reversal in the market. You don't have to plan for 2006-09 type of debacle, but be cautious.
  • If you are in a secure job with reliable expectations of salary increases.

Nope, not for me.

  • If this is the home of your dreams, the neighborhood is perfect, and you want your babies to grow up here.
  • If the payments are a stretch now, and the prospects of better income are shaky.
  • If you're the anxious type. Worrying for five or seven years about what might happen is not healthy.  
  • If your marriage isn't solid. It's hard to buy a house on one income.

In all cases, shop carefully. Compare ARMs with conventional 30-year loans. Check out the fees. Always do the math. Get advice from a trusted friend or relative who understands numbers. Be aware that there are big differences between dreams and reality: Dreams go poof. Bad loans seem to stick around forever.


And one last thought: If the loan sounds too good to be true, it probably is. Despite ARMs' spotty history, almost nothing has been done to prevent bad things from happening again. Bad people will always be around.


More from MSN Money:

VIDEO ON MSN MONEY

23Comments
Mar 21, 2011 11:23PM
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Ummmmm.... Don't you get an arm because you think interest rates have a good chance of coming down in the next few years?  Right now interest rates are about as low as they could possibly get if you have a decent credit score, so why on earth would you go for an arm now when interest rates really have no where to go but up?  You will not find interest rates lower than right now.  If you can't afford a 30 year at these rates you are buying waaayyy to much house.
Mar 22, 2011 1:16AM
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Traditional ARM products were not the culprits behind the financial debacle. Rather, one of the main problems was a special type of ARM, better know as an Option ARM or Pick-a-Payment loan. This product was designed for real estate investors/flippers who have very short term financing needs. However, the product was abused and marketed to the average Jane and Joe as an affordable way to purchase a home or long-term investment property. This worked because one of the payment four payment options is to pay less than what is owed to keep up with the interest, resulting in an increasing principal balance. The other three payment options that borrowers could choose each month would be a full interest-only payment, a principal and interest payment based on a 30 year term or a principal and interest payment based on a 15 year term.

The coup de grace with Pick-a-Pay loans is that lenders allowed the principal balance to balloon to 115-120% of the original loan balance before an adjustment triggered an elimination of the lowest payment option, forcing you to pay at least the full amount of interest due per month.  Combine this with the rapidly declining market values of property and a perfect storm was brewed where borrowers could not refinance their upwardly adjusting Pick-a-Pay loan into a traditional ARM or Fixed rate mortgage, no matter how good their credit score was.

The truth is that borrowers who chose a traditional ARM during the 2004-2007 range are enjoying dramatically lower interest rates on their ARM today. The rate for an ARM is based upon an index.  One popular index that lenders use is the LIBOR (London InterBank Offered Rate). As bad as the U.S. economy has been, those of most European countries has been worse. Interest rates are just as low across the pond, if not lower, than in the U.S.  Good credit borrowers who did a 5/1 ARM in 2005 for example, probably started at a rate around 6% and their mortgage adjusted within the last year. Did the rate go up? Not even close.  These borrowers are now enjoying rates around 3% - a major windfall of monthly cash flow which can be used to pay down higher interest debt, mortgage principal reduction, or boost emergency savings accounts or nest egg contributions.

When interest rates start rising (and they will), ARMs have caps to protect you from too big of a payment increase at any one time. The max adjustment is typically 2%. For example, if you did a 5/1 ARM in 2005 at 6%, you are probably paying about 3% today and if rates skyrocket, the worse case scenario for your next mortgage rate adjustment would be up to 5%, still lower than where you started.  This gives you time to prepare for a refinance into a historically low Fixed mortgage if you expect to stay in your propety for the long term.

The correct mortgage product for you is primarily driven by one thing - how long you expect to own a property. In fact, if this is not one of the very first questions a mortgage originator asks you, I'd seriously consider shopping around for another licensed originator. Once you can ballpark an answer to that question, a good, licensed mortgage professional can provide you more intelligent options based on your personal situation. Asking friends or relatives for their advice? Not so much. You would not think to get tax advice or legal advice from them, nor should you rely upon advice from them about the single largest financial transaction you will probably make in your lifetime. Best to keep business spearate from friends and family and rely upon licensed experts for guidance in these matters.

Mar 21, 2011 11:10PM
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It's not just ARMs.  We are and have been moving back into doing the whole thing again.  We're absolutely flooding the globe with printed money to the tune of 2.3 million a minute.  Fannie Mae and Freddie Mac are the mortgage market.  Cars can be bought for nothing down, low or no interest and, naturally, if you can stagger into the dealer, you get a car.  We have to be the dumbest people on the planet. 

Mar 22, 2011 12:23AM
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Unbelievable, haven't people learned anything yet.  There's an idiot born every second.
Mar 22, 2011 8:24AM
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It usually goes up -- inflation is almost always with us -- but in theory the borrower's income and home value have at least kept stride, so you can make the bigger payments or sell the house. The alleged safety net is that, if you are like most Americans, you will have sold your home and moved long before the higher interest kicks in, or you can easily slip into a less-volatile 30-year loan.

 

This kind of crap is what got us in the situation we are in. This is what causes the housing prices to climb. Get a loan, live in a house for 3-5 years, and just sell it if you can't afford it. Yeah?! What happens when you can't sell your house because there are millions of people in the same boat.

 

Then there is the biggest danger of them all; the interest only ARM. That's how people got into houses they could never afford. The people then defaulted on their homes. Of course, got mad at the banks for putting the poor misinformed home in the position they were in. Walked out of their house (on par with the poor decision to get an interest only ARM) because "it wasn't right."

 

I can't believe there is a story out there about these kinds of loans. MSN must be getting some good rates for advertising from lenders to do this story.

Mar 22, 2011 2:33AM
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author gives every explanation in the book for what happened.

consumers never planned to keep paying on ARM"s after they adjusted. nor did most ARM borrowers plan to sell when the ARM adjusted, that's poppycock. Most ARM borrowers were aware of how high up their payments could go... but they assumed, were even coached by lenders, that they could simply refinance into a fixed rate when the ARM adjusted too much..

Only hitch... you need equity in your home to refinance...No equity. No refinance....

Also many borrowers knew that payment cap loans could go into negative financing.

Everyone likes to play the consumer dumb... and the evil banks and government... When the truth is many homeowners were speculating in the rising home market, one way or another, during the boom years.... Like investors. It's called greed and failing to look at the downside... a falling home market.... .And when the bust finally came it was the blame game because nobody wanted to take the losses....

 

I mean give me a break. The American consumer is not a dumb consumer. Whether it be cars, clothing, houses or what. Ameri

Mar 22, 2011 12:45AM
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The banks not need worry. They know free TARP money is only a lobbyist away.
Mar 22, 2011 6:24AM
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Did we learn nothing during the last 6 years? There was a cartoon in the paper in 1987, showing Indiana Jones signing the mortgage to his "temple of doom". It was an adjustable rate loan. I vowed never to sign one. Never have, never will! The sellers of such loans are the equivelant of the "money changers", which Jesus drove from the temple! Poor and middle clas people are usually the victims in this, and must not be taken in again!
Mar 22, 2011 8:43AM
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WOW!!!  I guess American's (in general) do not have the ability to learn for our mistakes.  Let's buy more than we can afford and finance it with an artificially low rate so the rate can go up and we can become more house poor or maybe foreclose. 

People, live within your means, rent for a while, save your money.  Don't be a slave to the banks.

Mar 22, 2011 9:06AM
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One in three mortgage holders have no or negative equity in their homes. In 2 more years it will be closer to one in two because the shadow inventory the banks are sitting on is enormous. Prices MUST come down. The banks fooled the people once...shame on the banks. Fool the people twice, shame on us.

Straight or option ARMs are toxic loan products. Beware !!

Mar 22, 2011 1:14AM
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Don't get an ARM, the bank told me my payments would not increase until the ARM came due. Within one year it increased by 30.00 and within 3 years almost 400.00 more a month. I couldn't do it anymore and ended up in foreclosure and bankruptcy. I tried to sell my home, but failed to do so. Take it from experience, ARM's are BAD NEWS!!!!

Mar 22, 2011 5:02AM
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After what seemed like a lifetime of thirty-Year adjustable-rate mortgages, with monthly mortgage payments going up all the time, The "Mortgage Refinance 123" helped me to lock in a great low fixed rate of 3.16%, helping me to guarantee myself the ability to always make my mortgage payment on time with money to spare.

Mar 22, 2011 7:26AM
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You got to be kidding. Just about lost my home to a ARM. It's the biggest rip off i've ever encounter. Better off to know what you a paying, it never went down that's for sure. Hook, line and sinker method.
Mar 22, 2011 7:58AM
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Used to be the two things you could always count on were taxes and death, well you can always count on the price of everything around you going up except your paycheck.  That is the way the banks and mortgage lenders sucker punched people into taking out those kind of mortgages.  The rates would go up, as your earning potential did.  Big joke!  Nobodys laughing...
Mar 22, 2011 9:50AM
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With interest rates still at record lows why would anyone in their right mind consider an Adjustable Rate Mortgage, Yes they have risen some but they are no where near the peak interest rates of the late 70's early 80's some above 16%, Fixed rate loans nowadays range in the 5% and some even lower range,

 

People need to do a little research before they sign any loan document, Quit blaming banks and realtors for your mistake. They are in business to make money and are not your friend, They are simply doing business as usual.

Mar 21, 2011 11:30PM
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ARMs are meant for RICH PEOPLE . Basically you are paying INTEREST on top of  INTEREST but...N.E.V.E.R...over the principal. _____________________________________________ Knowing that is UP TO YOU : YOU DON'T HAVE A GUN OVER YOUR HEAD. ___________________________________________________________________________ By the way, WHO IS ON TRIAL for the housing collapse ?    the answer is simple : NOBODY.  ___________________________ IS THERE ANYONE IN JAIL FROM COUNTRYSIDE ? Nope. __________________________________ Is there any chance to bring someone to justice from the AIG, Wall-street or Golden Sacks ? ? ?     Nope, they own some congressman and senator. 

Mar 22, 2011 7:24AM
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bank and fianance at it again i guess the need there bounus again taxpayer going to bail them out again you betlie cheat steal way to go great being an american rip off anyone you can take the money and run
Mar 22, 2011 12:20PM
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Remember, Anything the banks want is bad for consumers. Even Thomas Jefferson warned about the power of the banks and that was over 200 years ago.
Mar 22, 2011 12:13PM
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The facts are: 1. banks are trying to do away with 30 year mortgages, 2. ARMs were not the problem, it was negative ammortization and fraud by some borrowers and most of the banks and wall street that created the problem. It is amazing that we are allowing the banks to do the same things they did to create the great depression in the 1930s do it all over again. They created the depression by investing in the stock market, they created 5 year ARMs, they paid off Congress, they took nearly half of the homes people owned and there was massive wealth redistribution. Thanks to Phil Gramm, Chris Dodd, Barney Frank and the current Congress we have the same senario all over again. The only thing that is different is now there are 18 million unemployed who are armed to the teeth.
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