As rates rise, mortgage shoppers flock to ARMs
Once shunned and villainized, adjustable-rate mortgages are now being embraced by some buyers and refinancers. Is it worth the risk?
We are hearing more about adjustable-rate mortgages lately. But what about all the bad press ARMs got a few years ago? Is it really possible that an ARM might be a safe solution now for everyday homebuyers and owners?
ARMs, after all, were blamed for a boatload of misery in the housing crash. There were option ARMs (no longer available), where your debt ended up bigger than it was to start. There were interest-only ARMs, where your payments didn't shrink your loan balance at all.
There also were so-called "exploding ARMs," described this way in 2007 by The New York Times:
Especially ingenious — for lenders, at least — were so-called exploding A.R.M.’s that lured borrowers with unusually low teaser rates that then reset skyward two or three years later ... many of those loans that once carried low teaser rates are on track to reset to at least 11% — or more than four percentage points higher than the current rate on a conventional, 30-year home loan."ARMs: A "misconception"
But Bob Walters, chief economist for Quicken Loans, says much of that bad press was based on a misconception. The problem wasn't the ARMs, he says. It was the lenders.
"An ARM is nothing more than a (loan) structure," Walters says. The ARM itself is neither benign nor harmful to consumers. The specifics of your loan -- your initial interest rate, your eventual interest rate, how often the rate changes and the fees you pay -- depend entirely on your mortgage contract.
Walters blames shoddy lending practices for giving ARMs a bad name. In the boom, ARMs were marketed aggressively to subprime (low-credit score) borrowers who in many cases could not afford fixed-rate mortgages.
Lenders, Walters says, "made terrible underwriting choices." When qualifying borrowers, some ignored whether the borrower could afford the eventual higher payments.
The key to knowing if an ARM is right for you is understanding how ARMs work. By "structure," Walter means that an ARM is built like two loans in one. Your loan starts out as one thing and then, like a child in puberty, becomes something else entirely. At first it's a fixed-rate loan, and then it becomes an adjustable-rate mortgage.
The appeal of an ARM: Your payments are low in the initial fixed-rate period. Typical ARM terms are one, three, five, seven or 10 years. Your payments are low because your interest rate is low, usually lower than if you'd bought the standard, plain vanilla 30-year fixed-rate mortgage.
How to play it right
With interest rates rising, ARMs are looking good because they have much lower rates, to start, anyway. Today, according to Freddie Mac, where the average rate on a 30-year fixed rate mortgage is 4.40%, you'll pay 3.44% on a 15-year ARM, 3.23% on a 5-year ARM and 2.67% on a one-year ARM.
This chart shows what you stand to save compared with a 30-year fixed-rate loan:
30 Year Fixed
5 Year ARM
7 Year ARM
10 Year ARM
(Source: Quicken Loans)
If you play it right, you'll be out of the ARM -- by refinancing or selling your home -- before the fixed-rate part of the loan begins. ARMs began looking good again to consumers when fixed mortgage rates jumped three-quarters of a percentage point, starting in May. ARMs went from 5% of Quicken Loans' business to 20%.
"An ARM is perfect for someone who realizes they will not be in that mortgage in the long haul," Walters says. "Personally, I have never taken anything but ARMs. In the last 15 to 20 years I have profited enormously." However, he'll counsel friends and family to get fixed-rate loans, depending on their circumstances.
Even with new safeguards required since the crash, ARMs are complex contracts. The Consumer Financial Protection Bureau offers this brief primer on what to watch for. For a more-detailed look at the ins and outs, see the bureau's Consumer Handbook on ARMs (.PDF file.)
Used knowledgeably, an ARM can be great. I know folks, for example, who recently refinanced into an interest-only ARM. They are in their 60s. They plan to retire and move to a cheaper area in a few years. The recession left them minimally employed, in need of cash and living in a city where home prices have gone over the moon. Their nice, four-bedroom, middle-class home has become a gold mine.
The downside of their new mortgage: They're not paying a cent toward the principal of their home.
The upsides, though, are many: Their mortgage payment was slashed in half. That means they can stay on a few more years in their now-fancy, high-priced neighborhood. They plan to cash out before their current 3% interest rate resets, selling the home and paying off the mortgage.
Meanwhile, says my friend, "it's like renting our home except that we're getting it for about a third of what it would cost as a rental."
And yet, let me say it again: To take advantage of an ARM, play it safe. Get help deciding by asking the Consumer Financial Protection Bureau (855-411-2372) for help finding a free or low-cost HUD-trained housing counselor. Plan to get out of the mortgage and on to something else before your monthly costs start rising.
More from MSN Money:
- Home equity loans make quiet comeback
- How an 'affordable' home could cost you later
- Is it too late to refi? 5 steps to an answer
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