Understanding the Impact of ARMs (Adjustable Rate Mortgages)

Adjustable rate mortgages (ARMs) have been one of the most misunderstood and misused types of home financing in the United States since the day Congress gave lenders the green light in 1982. It is true that under the right set of circumstances an ARM can be a cost-effective short-term alternative to long-term fixed-rate financing. The potential short terms savings for very large loan amounts can be tremendous during the first few months or years. However, ARMs have also proven to be financially lethal in the wrong hands and under the wrong circumstances -- I'm referring to the many borrowers who underestimated or disregarded the gravity of the risks involved, and the lenders who went along with their plans.  

In this post I'll cover a handful of essential points about the impact of ARM financing with emphasis on one of the most common and popular types of ARMs -- the hybrid with its temporarily fixed rate. Here's a visual representation of a typical hybrid ARM:

Figure 1: An example Hybrid ARM with an introductory rate of 3%

ARMs became incredibly popular during the decade leading up to the housing market collapse primarily because of their attractively low initial rates when compared to fixed-rate financing.
Generally speaking, the shorter the fixed period of a hybrid ARM (#1 in Figure 1) the lower the introductory rate. Why? Because, conditions permitting, that initial rate could adjust upward sooner which would benefit the investor holding your mortgage note. Consequently, a 3/1 ARM is usually offered with a lower initial rate than a 5/1, which in turn is lower than a 10/1, and so on.

Point 1: Longer fixed rate periods provide greater long term stability. In exchange for a higher interest rate, fixed rate products such as a 10, 15 and 30yr (as well as hybrid ARMs with longer initial fixed rate periods such as the 7/1 and 10/1) protect borrowers from volatile markets for longer periods of time -- sort of a built-in "insurance policy" against rate hikes in an uncertain market and future.

The low introductory rates of ARMs enabled borrowers to qualify for higher loan amounts than they might have otherwise qualified for given their financial circumstances at the time. How? Borrowers only had to qualify at the introductory rate, not at the highest rate the loan might eventually adjust to in the future. While that pleased a great many borrowers who then sought even higher loan amounts, it also meant they were gambling on assumptions about their future circumstances. If the gamble failed to pay off and their introductory rate expired, they found themselves stuck in financing that was most likely going to grow more expensive with time.

Let's step back for a moment. How might I qualify for a larger loan amount by using an ARM? Well, one of the factors that a lender must use to determine how much I can afford is my debt-to-income ratio (DTI). The DTI equation looks like this:

DTI = (monthly debts + mortgage payment, taxes, insurance & fees) / Adjusted Gross Income

A lower initial interest rate translates directly into lower monthly mortgage payments for a given loan amount and term which, in turn, lowers my DTI ratio at my current income level. The lower the rate, the larger the loan amount I am able borrow before reaching the maximum DTI limit enforced by the lender under whatever the rules happen to be at that time. So long as I come up with the necessary downpayment, closing costs and reserve requirements, I could "afford" a larger loan amount. That is, until the day my interest rate begins to adjust upward.

Point 2: The rules have changed for 2014. Because borrowers and lenders alike abused ARM financing by determining qualification based on a temporary introductory rate, the Federal Government changed the rules. As of 2014, anyone who wishes to obtain ARM financing must qualify at the highest rate they would be expected to pay during the first 5 years of the loan -- taking into account the margin, index, timing of adjustments, etc.

Point 3: There is an upside to ARMs. In a perfect world markets behave, employment grows, investments thrive and the only direction is up. In such a world ARMs might be king. ARMs offer short-term savings versus their long-term fixed rate counterparts. In our current market, a 1% interest rate reduction translates to a $115-125 decrease in a monthly mortgage payment per $200k of the loan amount. For a 5/1 ARM that's up to $7500 "savings" per $200k over the course of its 5 year fixed period. To calculate the actual benefit we would need to consider the effect on investment and tax positions -- which may amplify or lessen the impact -- another reason to consult a financial or tax advisor.

Point 4: Favor facts over assumptions. As our world repeatedly reminds us -- it isn't perfect. If you plan to entertain an ARM it is imperative that you base your decision on reality and the facts before you, not unrealistic optimism or assumptions about your future. An ARM offers a relatively brief window of stability -- from as little as a month to several years or longer -- after which all bets are off. In the context of the 5/1 hybrid ARM used in Figure 1, if you have not successfully sold or refinanced your property before year six -- whatever the underlying reasons -- your monthly payment obligation will very likely begin to increase. By how much and how quickly? Well it depends on a number of factors including the specific terms (i.e. the margin, index, caps, etc.) of your ARM and the current market conditions. The interest rate on the ARM depicted in Figure 1 could increase by as much as two full percentage points (rising from 3 to 5%) in year 6. Assuming your budget can withstand the impact of the increased mortgage payment, the initial savings from point #3 can easily be wiped out within a couple years following the first adjustment.

Point 5: Take the time to understand how the adjustments work. Figure 1 illustrated a 5/1 2-2-6 ARM with an initial adjustment of up to 2% (emphasis in red). The terms of some ARMs permit a significantly larger initial adjustment following the reset date. For example, the first adjustment on a 3/1 5-2-5 ARM with an introductory rate of 3% could be as high as 5% (which also happens to be that particular ARM's lifetime cap). Or, to put it differently, in its 4th year this 3/1 ARM's interest rate could rise from 3% to 8% which would translate into a $624.00 increase in the monthly payment per $200k borrowed. [NOTE: To be fair, technically your rate could adjust downward instead if the terms and market conditions allow.] 

Point 6: Be aware of the difference between prime & subprime loan products. ARMs labeled 1/1, 3/1, 5/1, 7/1, 10/1 and so forth are generally prime products while those labeled 2/28, 3/27, 5/25, etc are subprime products. At first glance they appear to be similar, but the underlying rates and terms (i.e., the fine print) can be quite different. One of the most obvious differences, visually anyway, is the number following the slash. With prime products that number represents the frequency with which the rate will change following the fixed rate period -- depicted as #2 in Figure 1. With subprime products the number following the slash represents the number of years over which the rate is adjustable -- e.g., a 3/27 subprime ARM is fixed for the first 3 years and adjustable for the remaining 27 (the same as its prime 3/1 cousin). However, the actual frequency with which the rate of the subprime ARM will adjust appears elsewhere in its terms and conditions. A lender should always assess your eligibility for prime products first before considering anything subprime -- make sure you speak with at least 2-3 lenders to find out. Prime rates and terms are better overall. 

Point 7: Be aware of the potential for negative amortization (a.k.a. "neg-am"). That's when your loan balance increases over time even if you're making payments in full and on time. One of the many ways this can occur is when your monthly payment isn't enough to keep pace with accruing interest. If you're in an ARM with a payment cap, any amount due each month over and above your capped payment is still owed to the lender and will be added to your loan balance. In other words, if your monthly payment is not large enough to cover the monthly interest and at least some principal, you will be moving further from your goal (to pay off your home) with each payment -- probably not the type of financial arrangement you have in mind. 

Point 8: Worst case scenarios can offer valuable insight. I'm not suggesting that you become a pessimist. That would not be in your best-interest. However, you should always assess the value of an ARM in the context of your worst case scenario. If you should find yourself unable to sell or refinance before the ARM begins to adjust, how might the increased mortgage payment affect your quality of life and ability to sustain the property? What resources might you have at your disposal to weather unanticipated hardships? Are you risk averse? Might long-term fixed rate financing make more sense? Only you know the answers to these questions. At least you will have taken these factors into consideration.

Point 9: Read everything that you receive from your loan servicer. From time to time, for the duration of your loan you'll receive notices from the servicer by mail. These notices may or may not be bundled with your statement. Read them. Several months before your first interest rate adjustment you will be informed of the upcoming rate adjustment, the new payment amount, other options you may have, etc. For each adjustment thereafter you'll receive a similar notice approximately 2 months in advance of the actual adjustment. Some borrowers claim that they were never told that they would receive advance notice of adjustments, or that they have never received such notices by mail. While it is always possible for such an oversight to occur, more often than not they a) failed to read the fine print provided when they acquired the loan, or b) they never noticed, opened or read the notifications, or c) the details were explained to them and they did read the notices but they simply have no recollection of either.

This is not a case of "buyer beware". Rather, it's one of "buyer be aware". It was certainly easier to justify the use of ARMs during a market free fall (2007-2013) than in today's market with interest rates creeping upward. However, if you have the means and ability to assume the risk, and you qualify under current standards, and stand to benefit from adjustable rate financing, then you can certainly add ARMs to your list of viable financing options. I strongly suggest that you consult with a financial and/or tax advisor as well as an experienced loan officer for further guidance.

And, for additional information about ARMs I recommend this easy to read handbook published by the Consumer Financial Protection Bureau:

http://files.consumerfinance.gov/f/201401_cfpb_booklet_charm.pdf

I wish you and your family all the best.

Home Financing Pre-approvals That Aren't -- And How You Can Opt Out

If you own a home or you've applied for financing in the past, chances are excellent that you've received one of the many types of junk mail designed to attract your attention, and your business. The bulk of this type of mail is known as "prescreened" offers.

Below is an image of an actual "Loan Pak" received earlier this month. The package is always designed to appear very official with insignias and signatures (blue arrows) and usually mentions that this is a "pre-approval" valid only until date X and that you are pre-approved for an amount up to $Y (the red arrows).

Inside you'll find a couple pages filled with more official-looking language, tempting rates, and an offer that seems too good to refuse -- complete with accompanying stock photos of unknown smiling families and fawning testimonials.

There's a catch: you haven't been pre-approved for anything. The rate and loan amounts shown are irrelevant -- they're teasers. Your credit information was sold by one or more of the big three credit reporting agencies (TransUnion, Experian and Equifax) without your permission -- by law, initially they do not need your permission. The company that purchased the information mailed thousands of mock "pre-approvals" to home shoppers and owners hoping a profitable percentage of the recipients will contact them. The document you have received is, at best, a "pre-qualification", but even that is a stretch. Unlike pre-approvals, pre-qualifications are not based on documented, verified evidence and have virtually no value in the real world.

Until a lender pulls your credit, reviews your credit history, receives and reviews all of your supporting income and asset documentation, and understands precisely what type of property you wish to purchase/refinance and where it is (or will be) located, there can be no pre-approval. Only after a thorough review of your circumstances can a loan officer tell you precisely how much you would qualify to borrow as well as the programs and products available to you and at which rates and points specific to your creditworthiness and risk. The lender may provide you with a pre-approval if there are no outstanding issues that would prohibit them from offering one.

What do we do when we receive prescreened offers at home? We throw them out. Frankly, we prefer to deal with local professionals in support of local communities rather than some virtually unknown lender with an office in another State or halfway across the country. These days we receive very few such offers because I've "opted out" but my wife hasn't yet.

Should you choose to inquire about a pre-screened offer please proceed with caution. Keep in mind that the company must collect and review some very personal documents and you don't know anything at all about the individual or company assisting you on the other end of the line -- including his or her experience, expertise or track record. [NOTE: There are methods available to you to research the lender and loan officer, however I'll leave that topic for another time.] The rates, terms and loan amounts quoted over the phone will very likely not match the information that appeared in the junk mail offer -- always read the fine print.

If you're not already aware of it, you have the power to opt out of receiving pre-screened offers. In other words you have the power to tell the three credit reporting agencies that they do not have your permission to sell your information to third parties. With a single phone call or online form you can opt out for five years. By printing out and mailing a signed copy of the online form you can opt out permanently. Think of this as a supplement to the Do Not Call list.

www.optoutprescreen.com
Toll-free 1-888-5-OPT-OUT (1-888-567-8688) 

And if you're serious about obtaining an actual pre-approval, we encourage you to work with a local loan officer. The company headquarters need not be local, but the loan officer should be. Financing a home is one of the largest, most complex and expensive transactions you will conduct in your lifetime -- is this really something you'd rather do over the phone with someone you've never met not vetted? Why not meet face to face even if only to initiate the conversation? The choice is yours.

I hope you found this helpful and I wish you all the very best.

Should I Rent My Current Home So That I May Purchase Another? Well...

Choosing to rent one's current home and also purchase a new primary residence isn't a decision to be made lightly. A homeowner's ability to take advantage of this particular arrangement depends on a number of factors about which they may not be fully aware. 

Most obviously, homeowners should consider whether they have the desire to become landlords with all the responsibilities and potential expenses of the role, especially in a State such as Massachusetts in which the laws are very pro tenant. It's relatively easy to find a tenant but not nearly as simple to sever the relationship should it take a turn for the worse. And should a landlord ever decide to sell, the presence of a tenant will play a role in the transaction especially if a buyer plans to finance rather than pay cash. The buyer may also be expected to assume the seller's obligations to the tenant.

If you are serious about buying a new home and turning your current home into an investment rental, here are just a few of the many things you should keep in mind:

• "The best defense is a good offense." Seems like common sense, doesn't it? It isn't. There are countless stories of homeowners turned landlords who regret not doing their homework first. Typically they speak with an attorney after something has already gone wrong with the deal hoping they can now fix a situation that could have been averted altogether with less expense and aggravation.

• Begin by speaking with an experienced loan officer -- emphasis on experienced -- and explain what you hope to accomplish. The LO will tell you what you need to do to successfully obtain financing for your new home in the context of retaining your current home as an investment property. If everything is in order, you should be able to obtain a pre-approval for your next home.

• Expect to be asked about the reason for your desired move (especially if the two properties are less than 50 miles or so apart). Your reason will need to be acceptable by current financing and fraud standards. Your LO and underwriter must prove that you're not engaging in "buy and bail" fraud. Buy and bail is simply buying a new home with intent to dump the previous one -- and lenders are expected by the government to be on the lookout for fraud. Understand that it's nothing against you personally. 

• You may be expected to show sufficient equity in the existing property -- the magic number is generally as high as 30%. Should you lack sufficient equity, ask your loan officer what other options might be available to you (e.g. paying down the existing mortgage to an appropriate level, or using a different loan product that might allow for less equity in the soon-to-be investment property).

• You will only be able to apply a portion of rental income toward qualifying income if you meet the requirements of the specific loan product and lender. In some cases, a signed lease agreement from a renter and proof of the security deposit is sufficient (e.g. FHA), while in others the lender may require a 2 year history of rental income as documented in your filed tax returns. Absent the required proof, you'll have to qualify to carry both mortgages as well as any other debts based solely on your income from sources other than rental income.  

• Secure the services of an experienced real estate attorney. Explain what you plan to do and have your attorney walk you through everything that must be accomplished from a contractual perspective, especially your obligations to the tenant (and vice versa) once you assume the role of landlord. While you're at it, ask your attorney to explain what will be expected of you should you ever decide to sell the property. 

• When you do finally go home shopping, if you fall in love with a home that is currently occupied by the seller's tenant get your attorney involved right away before making an offer. Your goal is to fully understand and assess the opportunity up front to avoid headaches, unanticipated expenses and disappointment later.

[UPDATE 3/21/2014] There are a number of other factors and considerations beyond those highlighted above. For example, you'll pay for two appraisals, one for each property. You'll be expected to show several months of liquid reserves for each property beyond the funds required for closing (i.e. typically as much as 6 full mortgage payments per property). Your credit history and scores will have an impact on everything from the cost of the interest rates available, to the loan products available, and the minimum required size of your downpayment. The existence of a second mortgage, home equity line, etc. may affect refinancing in the future especially if the liens are with a different lender (resubordination can quickly complicate refinancing). This list goes on an on which is why it's so important to consult with your loan officer and attorney very early in the process before making any plans. [/UPDATE]

Can turning your existing property into a rental be a great way to transition into your next home, and potentially generate some additional income? Absolutely! So long as you prepare yourself, put together an experienced support team (loan officer, attorney, real estate agent, etc), identify any potential issues early on, swiftly address the issues and think ahead, but never get ahead of yourself.

As always, I wish you all the very best.

Weighing the Cost of Refinancing

First, thanks to Jim Moran for giving me the opportunity to contribute to his excellent community-focused website. This is my inaugural article and I hope the first of many. I chose a topic that weighs on the minds of many people across the country and right here in our community - refinancing. Feel free to contact me if you have questions about anything I post.

Never underestimate the power of refinancing -- from lowering interest rates or monthly payments to providing cash for mounting debts or speeding up loan pay-off. It's up to you to weigh the benefits of refinancing against the potential impact of the status quo. Below are a just few examples of ways in which homeowners can leverage refinancing to address their ever-changing needs and goals.

Refinancing to Lower Monthly Payments

Let's say a couple begins to feel the burden of their $150k 15yr 3% fixed payment of $1,035 perhaps due to a recent increase in their property tax or homeowner's insurance or a new and unanticipated expense. Whatever the reason, they feel that they must lower their monthly payment to make ends meet. Yes, 3% was an amazing rate when they refinanced a couple years ago, but it's irrelevant. They have already identified and dealt with other expenses (i.e., they have reduced or eliminated as much as they could) and now they've turned their attention to their monthly mortgage obligation before it begins affecting their quality of life. 

What to do? Well, they should avoid making too many assumptions and resist treating assumptions as facts. Maybe income will increase. Maybe taxes will go down (don't we all wish!). Maybe in a year or two things will turn around, right? Perhaps, but is the couple prepared to take that risk? Can they afford to absorb the consequences if they're wrong? Millions of people made similar assumptions about their finances and the future and we all know how that turned out in 2006-2007 when all those assumptions went right out the window along with income and equity few homeowners could afford to lose. These days, it's all about facts and outcomes.

So, what about refinancing to lower their monthly payment? Here's a fact: a 30yr 5% fixed refi -- even with 100% of the closing costs rolled into the loan -- would lower the couple's monthly payment to $826. Is it ideal? Of course not. In fact, the rate is higher, the term twice as long, and if they never sell the house or refinance again (though most will), they'll pay considerably more interest than the current loan terms. Under ordinary circumstances most families would say no, thank you. However, recent years have been anything but ordinary. Depending on this couple's circumstances that $200/m reduction in their mortgage payment might make a huge difference in their day-to-day quality of life and ability to stay afloat. For too many families in and around Longmeadow that's a reality and other avenues such as finding alternative ways to reduce current expenses may not be enough.

The scenarios are endless: refinancing from an adjustable rate mortgage (ARM) into a longer-term fixed rate loan, or from one ARM into another to put off the inevitable rate increase, or increasing the duration of the current fixed rate loan, and so on. 

Yes, in today's market with rising interest rates a refinance isn't quite as attractive as it was during the depths of the recent recession, but those historically low rates are gone. Still, we are a long way from the 17+% peak interest rates of the early 80s. You may find or feel that you have no choice but to refinance even at today's rates. You can either lower your minimum monthly payment obligation knowing that the long term overall cost may be higher, or you can deal with the fallout from a monthly payment that has already proven itself to be unsustainable even in the short term. Will it feel as if you've taken a step backward? Initially, perhaps. But if it means freeing up current income to pay other equally important expenses, sometimes we have to take a step or two backward in order to make ends meet and move forward.

Depending on how dire your situation has become, or the direction in which it may be headed, refinancing may not be an option available to you. For example, if your home's value is currently less than what you owe on it (a.k.a. being "upside down") or you've already begun making late payments, or you have a second mortgage with a different lender that is unwilling to resubordinate the lien, then refinancing may no longer be an option. However, other options such as mortgage modification, regular sale, or short sale may still be available. It's best to consult a real estate attorney to understand your rights and protect your interests before entertaining a mortgage modification or a sale of any type. Often the initial consultation is free. Frankly, you're not going to be thrilled by any of the options, but with so much at stake the worst possible decision is to do nothing at all. Just remember, the amount by which you could reduce your monthly obligation will depend on your specific circumstances, and the terms available to you. 

Refinancing to Draw Cash Out or Consolidate Debt

While a majority of homeowners have used refinancing to lower their monthly payments in recent years, there are other uses for it. For example, if you have sufficient equity in a property you may be able to extract some of that equity through what is known as a "cash-out refinance".  There is always a limit to exactly how much equity you can access and it will depend on several factors including but not limited to how much you currently owe on the property as well as how you're using it (i.e. as a primary residence, second home, or investment property) and whether or not your current income and assets can support a larger loan amount.

Let's say you own a primary residence with a current appraised value of  $250,000 and a mortgage balance of $125,000 (50%). If the lender with whom you're dealing allows up to 80% loan-to-value on a cash-out refinance of a primary residence, you may be able to draw out up to 30% of the home's value in cash to use as you wish (minus closing costs if you choose to roll the costs into the new loan). Homeowners use cash out refinancing -- as well as related financing such as home equity loans and lines of credit -- for a variety of purposes from remodeling and repairing their property to paying for their child's education, paying off debts that carry significantly higher interest rates, or even taking vacations.

Would your monthly payment be higher, lower or about the same? Again that will depend on a number of factors including how much equity you wish to cash-out as well as your original terms versus your new terms. You should consider the benefits of a cash-out refinance (e.g., paying down high-interest debts, putting a child through school, etc.) versus the costs (i.e., the higher loan amount and new terms). You should also consider whether a home equity line or loan would make more sense -- both are usually available with lender paid closing costs and without altering the terms of your current mortgage. 

Refinancing to Build Equity Faster

No discussion about refinancing would be complete without mentioning how to leverage it to pay off a remaining loan balance more quickly and at a lower cost. Should you have the means to do so, you may be able to refinance into a more aggressive payment schedule, possibly at an interest rate lower than your current rate if you haven't already refinanced in the past couple of years. 

Before you entertain refinancing to build equity more quickly, keep in mind that you can accomplish the same basic goal without refinancing by making additional payments toward your principal. Even an extra $100 per could potentially trim months or years off of a mortgage at your current rate and terms. You can use any online "early payoff" calculator to determine how much you'll save in time and money for a given size additional monthly payment in the context of your current mortgage. Nevertheless, refinancing may offer a favorable combination of financial and tax benefits that additional payments toward principal cannot. 

Proceed with Caution 

What seems like the best option intuitively, may not be. For example, many consumers are under the mistaken impression that purchasing a home with cash is always better than having a mortgage, or that shorter loan terms are best. There is no universally correct answer because it depends on your unique set of circumstances (i.e., your tax position, investments, assets, goals, etc). This is where your financial advisor, tax advisor and loan officer can be of tremendous help.

Make the time to speak to your local loan officer and professional advisors about your situation to find out which options are available to you and how they compare. With rates steadily creeping upward since this time last year, now is definitely not the time to procrastinate. 

Whatever you choose to do, all the best to you and your family in 2014.