An Adjustable Rate Mortgage primer. Sorry if it's long, but it has to be.

[bluesbassman]

I am a mortgage professional. I have worked as a licensed broker and an institutional loan officer. In light of the current state of affairs in the housing market, I have come to believe that there is a general lack of understanding in how Adjustable Rate Mortgages actually work. I have written the proceeding explanations based on my knowledge of the past and current mortgage market. As I am in California, I have used examples of products that are available here. Your state may have variations, but I believe the core principles apply. Always consult a knowledgeable advisor when making any decisions about your specific mortgage management strategy.

There are several types of "ARM" mortgages. The most common is the "Fixed Rate ARM", usually executed as a 3, 5, 7, or 10 year fixed rate term. These loans are typically indexed to the MTA, LIBOR or CMT indexes. The adjustment happens at the end of the "fixed" term, and is usually a 1 year adjustment, "fixing" the new rate at the current index value plus a preset margin. There have been abuses using these types, typically with the so called 2-28s and 3-27s, where the borrower is given a "prepayment" penalty that exceeds the fixed rate period, and are "trapped" when the adjustment happens. These loans were often used in the so-called "Sub-Prime" market, and enabled borrowers that would not qualify on a normal home to purchase. However, based on the homeowners needs, the regular ARM loans can be a valuable mortgage management strategy as the interest rates are typically lower than the traditional 30 year fixed.

The second type of ARM, is the "One Month" type, and as the name implies they can ad do adjust every month according to the value of the index they are tied to. These loans typically have a significantly lower rate than the 30 year fixed, and as a mortgage strategy are used in a "bridge" scenario where the borrower anticipates either selling or refinancing the property quickly. The obvious drawback to this type of mortgage is the volatility of the market, and the possibility for a rapid increase in the rate and corresponding payment. These loans are really for the savvy borrower, to be used as a mortgage management strategy. Again, these loans were abused and a lot of first time home buyers were placed in these loans as a way to qualify for more than they could afford.

The last type of ARM is the so-called "Option ARM" or "Pick-a-Pay" loan. These loans are without a doubt the most misunderstood, and abused loan in the mortgage industry. Without going into the history of this loan's development, basically what these loans offer is four different payment options. The first being a 30 year amortized payment, the second a 15 year amortized, the third an interest only an the fourth a "Minimum Payment" Let me break these down:

"30/15 year Amortized" - This payment is calculated using the "fully indexed" rate (The "Index" the loan is tied to plus the preset "fixed" margin) and amortizing it over a 30/15 year period. This so-called “fully indexed’ rate is the real interest rate that is accruing against the unpaid principal balance. This feature of the loan is where a lot of people came to believe, either through deceit on the part of the loan agent or ignorance on their part, that they had a 30/15 year fixed loan.

“Interest Only” – Pretty straight forward, the payment is calculated using the “fully indexed” rate multiplied by the current principal balance and dividing by twelve. This is the same way a “fixed rate” ARM interest only payment is calculated. The difference is that the “fully indexed” rate will change month-to-month depending on what the “index” is at.

“Minimum Payment” – Okay, here we go. This option is what most people don’t understand and what has gotten most people into trouble. Essentially this payment is pulled out of thin air, and has no relationship to the “fully indexed” rate at all. What the lender does is to come up with an arbitrary interest rate, let’s say 1%, and apply that rate to the original loan amount, amortizing it over 30 years. This results in a situation called “negative amortization” as the “minimum” payment does not meet the interest that is accruing at the “fully indexed’ rate. In the early months of the loan, this difference is not too large, so a lot of people miss the fact that their principal balance is growing. Continued use of the minimum payment however, increases the principal balance, and the corresponding interest accrued against the principal balance.

The minimum payment has some “safety” features (although who exactly is getting the “safety" is debatable). First, the minimum payment can adjust every year to a maximum of 7.5% of the original payment amount (to attempt to minimize the negative amortization) and second, there is usually a principal balance limit of 110% of the original loan amount before the entire principal balance is “recast” into a straight 30 year fixed loan.

The minimum payment feature is a useful tool for cash flow (a lot of investors used this loan), and in a rising market is an attractive feature. In a declining market, obviously the increase in principal balance and the decrease in home value can eat up a lot of equity, so again, this type of loan should be considered after careful examination of the transaction. Unfortunately, this was not the case in many instances, and a lot of people used this loan to qualify for property that they could not really afford, and some bought speculating that their property would appreciate enough to cover the increase in principal balance.

I hope this give you a little better understanding of Adjustable Rate Mortgages, and how they are used.

[cliffordu]

1. Here's my question:

Aren't these all little more than Usury? At the minimum they seem to be exploiting greed on one hand and gullability on the other.


I don't know how any of them run to full term.

And, frankly, I wouldn't trust anyone with a checkbook who'd actually sign up for one.

[bluesbassman]

4. I don't see usury in these programs.

To be usurious, the rates would have to be significantly higher than "normal", when in fact, the fixed rate ARMS typically have a lower rate than the "traditional" 30 year fixed. The issue is what happens at the adjustment period. Most modern ARM's have yearly and lifetime caps. Typically the yearly caps are 2%, and the lifetime is 5%. These caps work both way up or down. Bear in mind that the "indexes" that these loans are tied to move up and down. For instance, the 1 year LIBOR is currently at about 3.4 yet a year ago it was at 5.25. So if someone had a 5 year ARM with a margin of 2.25 (typical) that was maturing today, their new rate would be 5.65%.

So let's say that they stated their loan at 5%. They would now have a new one year fixed rate payment at 5.65%, so their effective rate increased by .65%. Not to bad, but it is an increase, so where is the benefit? Well, when they had originated the loan, the 30year fixed rate was most likely anywhere from .5% to 1% higher than what they ARM rate was, so that 60 month period resulted in a substantial real dollar savings.

From my perspective though, it really boils down to how you are going to deal with the property. If it's your first home, there is a better than average chance that you will not be in the home for more than 5 years (the national average is 7 years BTW). So, in this instance a 5yr ARM may be a proper strategy. As to your first point, yes they can be used to exploit greed and gullibility, but that depends on the parties involved. Any financial transaction can have that effect. The problem over the past few years is that we had a super heated hosing market that attracted unscrupulous people on all sides of the deal.

So to address your second point, the loan isn't designed to go "full term". It is designed to be an incremental period loan, that could extend beyond the initial fixed period depending on the circumstances. I always make sure that people understand exactly what they are getting, and what the pros and cons are. Ultimately it's their decision to make on what best fits their risk tolerance and financial goals.

[cliffordu]

11. Do you have a breakdown of how many of these ARMs

are going down the tubes compared to straight up fixed rate mortgages??

I would expect, if they are a grand deal as implied, that FEWER of these would be in default. That's why people get these instead of fixed rate, right?



This reminds me of the low rate credit card schemes.

[bluesbassman]

15. The ratio is higher for ARM defaults for one simple reason.

There were many more people put into sub-prime ARMs because that's what their credit scenario dictated. These borrowers were by definition a higher credit risk, so when the housing market and economy slumped, it was reasonable to see them default. A large portion of borrowers in this situation would have defaulted whether they had a 30 year fixed or an ARM. The difference is because the were riskier to begin with, they had fewer options at origination. The bottom line here is that if the guidelines were more restrictive at the time, a lot of the people who are defaulting now, would not have been able to buy a house in the first place. It's not necessarily the fault of the loan product they used.

Granted, there were people put so-called ALT-A and Subprime loans that should not have been, and that is an area of mortgage lending that needs to be addressed through regulation to prevent future abuses.

[hfojvt]

7. some of them are standard home loans

so I don't know what the basis is for your question.

When I bought my house I got a 5,1 Arm. My payment was amortized at 30 years and my rate was only fixed for five years, at which point I would need to refinance. With the ARM I got a lower rate (by .25% or so) than the 30 year fixed. True, that was, at most, $70 a year, but for me, even ten bucks is ten bucks.

My reasoning went like this. I was making about $23,000 a year at my job. Over 5 years, my total wages would be $115,000. I was buying a $35,000 house with 20% down, meaning that I owed $28,000 plus interest. If I could not pay $28,000 out of $115,000 income, then something would be seriously wrong.

Of course, it turned out that I got fired from my job a mere three months into my mortgage.

But I still made payments on unemployment checks for five months, and paid off the house in about 3 years and ten months, saving something like $15,000 - $20,000 in interest charges.

[cliffordu]

12. Your situation seems like it was a reasonable move for that time....

Because you paid the loan off in 3 years and 10 months out, which means you had, for all practical purposes, a standard fixed rate loan. Now look at what I'm talking about:

Use your scenario above except;

Say you wanted a $500,000 house and you were making $75,000 a year.

And let's say the rime rate went from 3.00 to, oh, 3.8

Now what?

[1]

2. clear, concise... but why?

if i am going to enter into a contract that will span 30-50 years?

why would i enter into a contract where the interest rate could go up?



sorry bud. i don't buy it.

[bluesbassman]

5. See my response to the first post for clarification.

[jmowreader]

20. Because you're not planning to keep the house 30-50 years

IIRC the "average American" changes homes every five to seven years. If you KNOW you're going to be out of the house in, say, three years (this is very common in Fayetteville, thanks to our large military population), why not take the lower-interest loan?

[cliffordu]

3. Is this DU's first "mortgage troll"

:rofl:

[bluesbassman]

6. No, I just take a while to type.

I have originated hundreds of loans. The majority being ARM type. The current market has brought the gap between ARMs and 30 year fixed closer, so I'm seeing more people choose the 30 year option. They are still paying a little more in interest, but their risk tolerance makes them more comfortable with the 30 year. Will they probably not be in that loan five years from now? Yes, but as I said in my response to your first post, it's ultimately their decision, and if that's what makes the most sense to them, then that's what they should do.

An additional point is that I am in the Bay Area market where prices are high. A difference of a .5% can be a lot in monthly payment. In other parts of the country it could be well under $100 and might make the comparison less striking.

[lildreamer316]

10. Dumb question:

Can someone in a fixed 30 year refinance at a point (say five years in; ten years in, etc.)? I am referring to a traditional fixed rate loan.

Thanks so much for the info. Husband and I have found our dream home; and are hoping to make a move on it this fall. I am a newbie to this, so I need all the info I can get! Don't mind the others. :)

[bluesbassman]

14. Most 30 year fixed have no prepayment penalty.

So yes you could refinance at any time. This is also true for the ARM loans, although there can be a prepay. The prepay must be disclosed, so it is important to review you loan docs carefully at signing.

My purpose in sharing this information was not to advocate for any particular loan, but rather to illuminate what the ARM loans are, and why they're used. I'm glad the information was useful to you and I wish you the best in you future home purchase.:hi:

[rucky]

17. The Fed has pretty much gotten rid of the prepayment penalty.

http://money.cnn.com/2008/07/14/news/economy/fedrules/?postversion=2008071416

[bluesbassman]

19. Nice catch.

This really takes the nastiness out of the 2-28s and 3-27s that were abused in the sub-prime market.

BTW I heard that Wachovia, who took over World Savings (a major provider of the "Pick-a Pay" Loan), recently announced that all option ARM pre-payment penalties have been removed. If you have one of these loans, and would like to refinance out of it, check with Wachovia for details.

[FedUpWithIt All]

8. The problem was not the loans, as many like to think, it was the way they were marketed.

ARM programs are great for some people. Unfortunately they were being marketed to the masses. People were being sold on the minimum payment and little was done to explain the consequence of making nothing but a minimum. Lenders trying to sell people into a bigger home than they could afford did so by showing the minimum. They KNEW that without making this minimum people would not be able to afford their new homes. They KNEW that they would come up short on the tail end. They didn't care because they already got their commission.
Equity can be built faster than with a fixed but only if people are making a payment comparable to a going fixed rate payment. Turn around and quick to sell properties are great situations for ARM programs.

There was/is a LOT of dishonesty in the mortgage industry. I had a client that had a $50.00 difference between his total monthly income and his mortgage after he lost a part time second job. This type thing should not be happening.

[bdf]

9. It's not JUST the marketing, it's the time value of money

If somebody comes up to you and says they're going to give you $100 without any ties, and you can either have it now or in a year, which would you choose? OK, how about $100 now or $150 in a year? Assume the money is put into escrow if you choose the $150, so there's no chance of missing out if you wait. How much would it have to be in a year for you to wait? Now go through the exercise again, but this time assume that you outgoings so closely match your income that the day before payday you're down to pennies in your pocket.

The truth is you don't have to persuade people to take an ARM, you merely have to inform them that it exists and what the savings are over fixed-rate right now. Even if some are smart enough or informed enough to realize the possible future consequences, they'll take it. After all, in 5 years perhaps they'll be in a better-paid job. Or perhaps in 5 years they'll be unemployed and they couldn't keep up with repayments whichever option they chose.

[cliffordu]

13. And your last paragraph is why, on the CONSUMER end of our little mortgage crisis

we HAVE a mortgage crisis.

People actually believe that they can get something for nothing. Then they're surprised when they have to choose between paying the just-inflated house note or put gas in the car.

We are a culture that cannot own anything anymore; The car a dead hulk by the time most folks get them paid off, the houses that NEVER get paid off, along with the credit card debt that just keeps getting rolled over into new (temporary) zero rate cards.....


It's no wonder the middle class is almost gone. The interest rates gobbled it up.

(Edit for bad cut and paste and this):

I have zero debt and own my old Airstream outright.

[elehhhhna]

16. ARM's are NEVER to be taken when rates have nowhere to go but UP...

but good luck getting a fixed-rate w/o a zillion points in the last few years.

Offering ARMS when rates are at historic LOWS = fraud from the start.

[bluesbassman]

18. Not exactly true.

If a person has a reasonable expectation that they will only stay in the property for 3-5 years, why wouldn't a 5 or 7 year fixed rate ARM be appropriate for them?

ARMs are not for every scenario. The overall financial picture of the borrowers and the transaction itself should always be studied and applied accordingly.