Are Adjustable Rate Mortgages Worth It? Part I

The Adjustable Rate Mortgage (ARM) has become a popular way for Americans to get more immediate bang for their buck when purchasing a home.The question is, are adjustable rate mortgages worth it?

For a long time ARMs, also known as flexible and variable rate mortgages, have been considered a good option for buyers who are looking to sell their home or refinance in 3 to 5 years. The theory being that the homeowner makes lower payments with little risk of the mortgage payment being adjusted during that short time period.

Because the monthly payment on an ARM is considerably lower than that on a traditional fixed-rate mortgage, a buyer can qualify to purchase more home than they could if they took out a loan with a fixed-rate.  For the potential homeowner, this looks like a very attractive proposal.

The primary drawback to an ARM is the fact that if you hold onto the mortgage long enough it is almost certain to go up. Although exact times for periods of adjustment are stated, exactly how much and how many times it will rise is relatively unpredictable.

Much of what happens with an ARM depends upon developments in financial markets. If the interest rate on an ARM rises enough, one could end up paying more per month on a variable rate loan than one would on a fixed-rate mortgage.

However, with an ARM there are some protections afforded the home buyer. Most ARMs have limits or caps on how much an interest rate may change both during the length of the loan and the pre-determined adjustment period.

The loan contract for an ARM will state how long the adjustment period will be. Commonly, lengths of time regarding interest changes are six months or one, three or five years. If a consumer secures a loan with a one-year period of adjustment, then the rate may be changed on a specified date only one time per year. Additionally, if you’re so inclined at a future date, a lender may allow the consumer to convert the ARM to a fixed-rate mortgage.

When adjustable rate mortgages are definitely not worth it:

A word of warning concerns ARMs and negative amortization. Amortization is the reduction of any debt as achieved through loan payments. If an ARM has a negative amortization clause it negates most of the benefits that a cap offers.

Negative amortization occurs when the monthly payment is capped and the interest rises to a point where a homeowner is no longer paying the full monthly interest on the loan. That difference, between what one pays and what one owes, is added to the mortgage balance, increasing the debt owed. Not all ARMs are set up this way and it’s best to avoid those that are.

The worst case scenario for an ARM occurs when the rates rise higher than the fixed-rate and negative amortization occurs. In essence, a consumer can find him or herself unable to make payments on a home that continues to accumulate debt, possibly to the point where more money is owed on the home than it is worth.

If, however, rates go down or remain the same and the consumer is able to lock in, convert to a fixed-rate, refinance or sell, then they come out ahead. Switching to a fixed-rate will raise the monthly payment considerably, since this type of loan involves paying principal too.

There are a few things that you can do to help ensure you’re making the right decision and getting the best deal that you possibly can on your mortgage.

More on that in Part II

 

Understanding the Risks of Negative Amortization Home Loans

While these loans can be a good deal when short-term interest rates are low, they are not necessarily the right choice when short term loans have a higher interest rate.

Negative amortization or “neg am” occurs when the minimum payment on a mortgage covers less than the monthly interest charged, causing the balance of the loan to increase instead of decrease. Interest Only Loans generally don’t increase the balance due on a home although they don’t diminish the amount due. However, deferred interest loans will increase your loan amount. This can happen with negative amortizations loans, like a Payment Option ARM, where payment choices can be calculated based on certain indexes used for these loans, giving you a variety of choices in payments. They are also known as “Pick a Payment Loans.” While these loans can be a good deal when short-term interest rates are low, they are not necessarily the right choice when short term loans have a higher interest rate.

If you are looking to eventually cash out home equity, you should look for a purchase loan that involves paying some of the principal. Not only is it possible you may not build equity in your home with neg am loans, you also may have a loss of equity through an increased mortgage balance. If you suddenly need to sell your home, you may not be able to get a purchase price high enough to cover your loan. You will also have more difficulty getting a second mortgage behind negative ARM loans.

On a deferred mortgage, the mortgage balance can increase as much as $350 per month for every $100,000 that’s borrowed. The neg am on a $500,000 loan for example, can be as much as $1,750 per month. While there are not many circumstances where I would recommend an Option ARM, there are a few instances where deferred interest or negative amortization loans may make sense.

Neg am loans are good for investment properties when you may be paying a double mortgage. They are also good for self-employed individuals with cash flow issues. If you plan on normally paying some of the principal, but don’t know what your cash flow will be like from month to month, it may be helpful to have the option of a minimum payment.

Do your homework before deciding on a deferred interest mortgage. Although your payments will be lower, there are inherent risks involved and you may be better off with a fixed-rate mortgage.