Post-Meltdown Adjusted Rate Mortgages: Crazy or Savvy?

Post-Meltdown Adjusted Rate Mortgages: Crazy or Savvy?

In 2006 a mortgage loan originator had so many options to offer borrowers that it was mind boggling. 10-1, 7-1, 5-1, 5-6, 3-1, 3-6, 3-27, 2/28, 2-6 option arms, balloon notes…The list seemed to grow weekly if not daily. Then the market tumbled and the press reported that “the cause of the problem was massive amounts of ARMs resetting”. So why would anybody in their right mind entertain the thought of getting an adjustable rate mortgage now? In fact, why haven’t they been banned by the government sponsored enterprises that market them?

The fact is that they are still a viable product that makes good sense for the right borrower. The loan products were never the real problem, poor judgment was. ARMs were created to make a mortgage less expensive on the front end. The trade off is that you have a product that is less predictable in the back end. ARMs consist of a fixed rate for a period of years up front, that is the first number in a loan product’s name.  Take a 5-1 ARM as an example. It is fixed for 5 years at one rate that is usually lower than a competing 30 year fixed rate. The second number in the product name is the adjustment period, or how often the note adjusts once the fixed period is over. In this case our 5-1 ARM would adjust once every year after the end of the filth year. What type of borrower would this be a good match for?

One example would be a parent buying a condo for a child to live in while in college. At the end of 4 years the parent plans to put the unit up for sale. In this case the borrower knows going in that it will be a short term investment. The 5-1 ARM saves this borrower interest over a 30 year fixed rate and is therefore the best deal. The risk that the borrower assumes in this case would be the possibility of the adjustment period beginning before a buyer is found.

Luckily for our wise parent there is also a thing called caps. An ARM has at least three caps; the initial adjustment, the regular adjustment and the lifetime. This means that the amount the note rate is increased at the first adjustment is capped, the amount of change per adjustment thereafter is capped, and the note rate is only allowed to adjust a certain amount for the life of the loan. Federal Law mandates that the borrower be informed of these caps up front. Our parent understands that if the condo stays on the market over a year the interest rate could end up higher than the first five years, but the parent knows exactly how high it could go worse case scenario and has decided that even at that possible increase, the mortgage would still be affordable.

There are many other examples of reasons ARMS are a good choice, but they all revolve around taking advantage of the lower rate of the fixed period and selling or refinancing before the controlled risk of the adjustment period sets in. Although they have been given a dirty name in recent years, ARMs are likely to always be an option for American borrowers because they do serve a legitimate need and are a useful tool for the educated borrower.