Give me your ARM, and your leg too
From everything we are reading in the media today, an adjustable rate mortgage (ARM) is now considered to be a bad mortgage and the cause for today's mortgage mess. Unfortunately, that is the nature of the media, attention grabbing headlines that convey doom and gloom. The truth is that some ARM's are not just bad but toxic especially when chosen for all the wrong reasons. But in many cases (and with proper disclosure), an adjustable rate mortgage is a very good choice to finance your home.
Take today's Charleston South Carolina real estate market. There are a lot of homes for sale in the Charleston area and inventory is about double the norm. But the norm has always meant that a lot of homes are for sale because the nature of the Charleston real estate market is very fluid. Some people like to move every few years, others may be needing a larger home or downsizing and between the significant number of military personnel and government contractors who have traditionally moved to the Charleston area for only several years, there has always been a lot of turnover in housing.
I remember a few years ago when Chairman of the Federal Reserve Board Alan Greenspan suggested that homeowners who didn't plan on living in their homes for 30 years should not pay a higher interest rate associated with a 30 year fixed rate mortgage. With the typical person in the United States living in their homes for 7 years on average, an adjustable rate mortgage might make sense depending on your particular circumstances.
If you select a 3,5 or 7 year adjustable rate mortgage, your interest rate is fixed for exactly that length of time. After the initial period, your rate can reset (reset is now a nasty word) in most cases by a maximum of 2% per year and ultimately, there is a maximum interest rate that you could pay (generally 5% higher than the initial rate). Depending on what interest rates do during the term of your loan, the rate can go up or down or even stay the same. Of course, all we are hearing about now are rate resets that are much higher but we'll talk about that in a minute.
When it is appropriate for you to select an ARM, be sure that you plan to live in your home for only about the same number of years that you have selected to be fixed. Make sure that the rate is better for the ARM than a fixed rate would be and that if you change your plans, be prepared to make higher payments if the reset is higher. At today's current rates, you can expect the benefit of a slightly smaller monthly payment when selecting an ARM.
5.875% 30 year fixed
5.500% 5 year ARM
5.375% 3 year ARM
Now let's discuss one of the toxic loans that have given ARM's a bad name and have caused turmoil in the credit markets. We can start with the Option ARM, a clever product designed to enable the borrower to live in the house for the least possible payment. Not only does this adjustable rate product start with a low rate, it starts with an even lower rate than the real rates quoted above. When you see the ads for $500,000 homes with a monthly payment of $1400 or so, if it looks to good to be true, it is.
The real problem in the Option ARM is that it also is a negative amortization product as well as a below market interest rate product. What negative amortization means is that in exchange for a lower monthly payment, principal is being added to the original amount. So if you are only paying $1400 per month for a $500,000 home, at the end of the year, you may now owe something like $520,000. Surprise!
Another surprise! Your rate is now resetting too. Instead of that really attractive 1% rate, you will now have to pay 5% this year and 7% next year. Oops, that means higher monthly payments and maybe now you can't afford to live in that beautiful home any longer. Lots of people bought houses that way, that's why lots of homes are for sale and that's why lots of homes are headed for foreclosure. Thankfully, it is a bit less of a problem in the Charleston South Carolina real estate market than it is in much more overheated real estate markets that featured unsustainable rates of appreciation fueled primarily by speculation.
It's been said that the terms of these loans was not disclosed and that the borrowers didn't know what they were getting into. I would suggest that 99% of the borrowers knew exactly what they were signing and simply disregarded the potential consequence, in many cases they probably thought that they would just sell the house for an extra $100,000 or refinance it and take a little extra equity out while they were at it. When the real estate market stopped appreciating in many markets with prices declines in some areas and when many loan products were no longer available, neither option was available. Kaboom, mortgage mess.
While I'm on the subject of more dirty little words in the mortgage lexicon, prepayment penalties are another concept getting bad press. Essentially, if you plan to live in your house for more years than the prepayment penalty may apply, you can safely select that option in exchange for a slightly lower interest rate. Once again, be aware of what you are signing. The poster child for the mortgage mess is subprime loans, in other words, loans being made available to borrowers with less than stellar credit. Unfortunately, many prime borrowers took out equally disastrous loans in order to purchase a home.
Bottom line, all ARM's are not bad, be aware of the terms of your mortgage loan and don't pay an arm and a leg to buy a house that is beyond your means. And please, most importantly of all, understand what you are signing.