Adjustable Rate Mortgages: This Home Mortgage Loan May Not Be For The Weak At Heart
Adjustable Rate Mortgages: This Home Mortgage Loan May Not Be For The Weak At Heart
The Great Mortgage Debate: Fixed vs. Adjustable Rates
With news of another interest rate hike, I decided it was time to refinance my mortgage. My first call was to my mortgage company.
"I am interested in a fixed mortgage rate," I told the broker.
"May I ask why that is?" the broker inquired politely.
"I don't want to deal with the risk of rising interest rates. At my age, I cannot afford the risk."
The broker looked at my history. "You have done pretty well with the adjustable rate over the past ten years. You've paid less in interest than most people with a fixed loan. How about considering some adjustable rates, which are even lower than what you're paying now? With caps, you don’t have to worry about interest rate hikes. We could save you a few hundred dollars off your monthly payment."
I interrupted, "No thank you. I am only interested in fixed-rate mortgages."
He was puzzled. "Are you not interested in saving money?" he asked before launching into an elaborate explanation that combined economic theories, budgeting strategies, and an optimistic forecast of future interest rates.
When he finished, I explained, "I remember the 18%-19% interest on mortgage loans in the early 1980s. On a $100,000 loan, 18% interest is $1,500 per month just in interest. For a $200,000 loan, the interest alone would be a back-breaking $3,000 per month."
He probably thought I was out of my mind for considering an 18% mortgage interest rate in today's environment. Our conversation ended without resolution. The gap in understanding wasn’t about fixed-rate mortgages versus adjustable-rate mortgages (ARMs). It was a gap in age, experience, expectations, hopes, and fears—too wide to bridge.
Understanding Adjustable Rate Mortgages (ARMs)
Adjustable rate mortgages (ARMs) generally have lower initial rates compared to fixed-rate mortgages, making monthly payments lower and qualification easier.
Income and Loan Qualification:
Lenders consider what percentage of your income is available for repaying the loan.
For example, with an income of $5,000 per month, a $2,000 loan payment is 40% of your income, while a $1,000 payment is 20%. The closer you get to 20%, the easier it is to qualify for the loan.
Appeal to Younger Borrowers:
Young people, often optimistic about future income and likely to move within a few years, may prefer ARMs due to lower initial payments.
Renting seems like a waste of money compared to owning a home, even with the risks associated with ARMs.
Older Borrowers with Setbacks:
Older individuals who have suffered financial setbacks and have lower credit scores or incomes might also find ARMs appealing.
A poor credit score increases the interest rate on a fixed mortgage, making ARMs with their lower initial rates a more attractive option.
Key Terms in ARMs
Margin:
The lender's markup added to the index rate to determine your total interest rate.
ARM Indexes:
Benchmarks used to determine rate adjustments. The stability of the index affects the stability of your loan.
Adjustment Period:
The period during which your interest rate remains fixed before it adjusts. For example, a 5-1 ARM has a fixed rate for five years, then adjusts annually.
Interest Rate Caps:
Limits on how much the interest rate can increase.
Periodic Caps: Limit increases within an adjustment period (not all ARMs have these).
Overall Caps: Limit increases over the life of the loan (required by law since 1987).
Payment Caps: Limit how much your monthly payment can increase.
Negative Amortization:
Occurs when your payment doesn't cover the interest due, and the unpaid amount is added to your loan balance, increasing your total mortgage obligation.
Conclusion
When considering ARMs, it’s crucial to understand the terms and assess your financial situation. For some, the lower initial rates and easier qualification are beneficial, while others may prefer the stability and predictability of fixed-rate mortgages. As Henry Moore said, "What's important is finding out what works for you."
