Adjustable Arms

How Did Arms Put Homeowners Into a Bad Situation ?

Any one who has been paying attention to the news has to know what the term ARM means when it comes to real estate. The term ARM means Adjustable Rate Mortgage.

Most borrowers who are looking for a mortgage ask their bank or mortgage broker, three words, “What’s your rate?” Their only concern is the monthly payment and not what the loan will do three, five, seven or ten years from now. Especially, since statistics show that most homeowners move in five to seven years. So, why get should Joe the homeowner get a loan for any longer than that period. Plus, statistics showed that homes appreciate three to five percent annually historically. Well, history does not follow past patterns.  This is even more evident when existing homes and new homes were appreciating by 20 to 25% in recent years. Homeowners are finding themselves in a difficult situation when rates move up and their home value has decreased or stagnant.

Did you know that still today, 34% of homeowners cannot explain what an ARM is ? When selecting an ARM, you’ll be given fractional numbers such as 3/1, 5/1 or 7/1. This shows the number of years that the initial mortgage interest rate stays fixed, and how often it will change after that. For example, a 5/1 ARM will stay at the initial interest rate for the first 5 years. After that period, it will adjust once each year.

An ARM adjusts based on the index it is pegged to. The most common indices used to calculate the interest rate on an ARM are the London Interbank Offered Rate (LIBOR),  the 1, 3 or 5 year U.S. Treasury notes, the 11th District Cost Of Funds Index (COFI), and the Prime Index rates. However, the borrower won’t pay these relatively low rates, the borrower pays the index rate plus a margin. The margin is typically a number from .25 to 6 above the index rate. As an example, if a homeowner has a 3/1 ARM that’s pegged to the Treasury, and your margin is 2.50%, once your ARM adjusts, you’ll pay the current market Treasury rate plus 2.50%. If the US Treasury index is 3.65%, so you’d pay 6.15%. That rate would stay the same until the next period of change.

Another important factor in an ARM is the cap. A cap is simply the maximum rate that the interest rate is allowed to rise. More often than not, the mortgage you receive will feature a lifetime cap and a cap for adjustments.

As a scenario for a cap, if your ARM adjusts up with a cap of 2% increase, your lender could only increase the interest rate upwards by a maximum of 2% in any adjustment period. Although, if the index rises by 2.5% in your adjustment period, the lender can only increase it by 2%, so you are helped. If the index rises another 1.5% in the second year, the lender can increase your rate another 2% to equal the overall increase and it is permitted in your ARM rate clause. This type of change is considered to be a carryover provision.

ARMs are considered excellent loans for people who are just starting out in their professions, due to the thought as they become more seasoned they will earn more money and can afford a larger payment. In the recent years, post 2000, many borrowers relied on refinancing their ARM into a fixed rate mortgage prior to the first adjustment period. So, if you had a 5/1 ARM you have a 5 year period to have a low comfortable payment and rate before the ARM resets to a higher rate. Most borrowers figured it would be automatic since home values increased from historical data.  However, once credit tightening happened and defaults rose, home values have come down and so has lending. Credit tightening was bound to occur when loans available to borrower with average to low credit scores were being approved for loans which featured no, no job, and no asset verification. Simply say what you have and you are approved. Now, that is downright ridiculous and should have never been allowed. The common stated income loan that does verify your job and does verify your assets has been around since the early 90’s but it always required 20 to 25 percent down. Lenders became more aggressive with zero down options which helped lure the kids into the candy shop.

As a result, a $2,000 payment soon became $2,500 or $3,000. Plus, if you had an interest only option and the interest only period was coming to an end you’re hurting. So, that’s a double thorn in the side. It turned into a triple or quadruple thorn for investors and second homeowners again banking on annual appreciation and small talk while in line at grocery stores. Now real estate is still the talk of the town but not one you want to bring up unless you are an investor or have access to lenders who are still relatively aggressive.

So, what will you do? Smart investors will refinance. There are some loans available that let you refinance even if your loan is more than your property value. It is called a Short Refinance. It is more common with a FHA refinance loan though.

About the Author

Frank Collins is an avid investor in real estate and contributor to Jumbo Home Mortgage and
a website to Find Low Mortgage Rates and trusted lenders in your area.

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