Call To ARMS
The straight story on Adjustable Rate Mortgages.
June 15, 2006
As the debate rages concerning the existence of a "bubble" in the American housing
market, one thing is for sure: Americans are loving Adjustable Rate Mortgages,
or ARMS. With interest rates stubbornly refusing to rise even in the face of
Federal Reserve tightening, the continuing demand for mortgages (of which some
70% is some form of refinancing) has spawned a whole host of innovations - interest-only
loans, no-down-payment loans, ARMS, and even so-called Option ARMS, in which
monthly payments are lower than the interest required and the difference is
added to the loan principle. This boom in mortgage methodology is a direct result
of both the record-low level of long-term interest rates and extreme length
of time they have remained so. Indeed, in 2003 no one had ever heard of option-ARMS.
Now some 40% of jumbo loans, or ones over $300,000 in principal value, are option-ARMS.
ARMS are very simple to understand. The interest rate you pay over the life
of a loan is variable and will change depending on the conditions stipulated
when you close. For instance, one of the most popular constructions right now
locks your interest rate for the first several years (typically five) then allows
it to float, or move, up to two percentage points in either direction each year.
Most ARMS also come with a floor, i.e. the lowest rate the loan will adjust
to, as well as a cap that limits the highest rate you will ever pay. Most ARMS
are tied to an underlying rate, such as the U.S. Discount Rate or something
called LIBOR - the London Interbank
Offered Rate - and can reset as much as four times per year.
So why are ARMS so popular? Easy - right now, with rates low, they usually offer
a lower payment than a traditional loan, thus allowing people to buy houses
they wouldn't normally able to afford. In fact, they've become so popular that
some 77% of mortgages originated in 2004 were ARMS, according to the securities
firm UBS. The problem comes if rates rise fast, rise significantly, or both.
In that case, a mortgage that was affordable a few years ago will adjust into
one that is very likely not. And although most of us have become very used to
the current combination of low rates and rapidly rising house prices, history
tells us that it is extremely unlikely that these two factors will continue
indefinitely. Effectively, Americans are betting heavily that history is wrong.
On the other hand, ARMS can be very useful. Obviously, just as they can adjust
upwards, they equally offer the allure of lower payments if interest rates decline
over the life of the loan. Additionally, many kinds of ARMS, including option-ARMS,
allow the holder to vary his or her payments within a range, perfect for anyone
working on commission or otherwise self-employed. Also, many ARMS carry set
rates for at least the first five years and in some cases as many as ten. This
makes them perfect for anyone who knows they'll be moving within that first
set rate period. This is significant, since the average American stays in one
house roughly seven years. Thus if you know you're moving, an ARM offers the
best of both worlds - lower payments AND a fixed rate for the period you expect
to be in the house anyway.
ARMS offer homeowners enormous flexibility and can dramatically lower the cost
of financing a house. Prudence, however, dictates that before you are lured
by the promise of more house than you thought you could afford, run some numbers.
Make sure that you can still afford the same house if, in a number of years,
interest rates have increased at the maximum allowable adjustment each year.
In some cases, you may find that the world has to remain as is for the duration
of the loan for it to be financially viable, and that's obviously not a smart
move. If, on the other hand, you find out that while a rapid rise in rates will
make your payments rise, you will still be able to "afford" the house even if
they do. And remember, the true "cost" of any such rise has to be seen in the
light of the money you saved before the adjustments by paying the lower ARM
rate instead of the one associated with a
traditional
30-year mortgage.
Other Articles by Steven Lord:
Other People's Money
Refi Boom Over?
Watching The Fed
