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.

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.