For people of a certain age, news that adjustable-rate mortgages (ARMs) are on the rise may cause many to shake their heads in disbelief. While many factors contributed to the foreclosure crisis of 2008, the steep climb of interest rates proved financially fatal for borrowers who suddenly found themselves facing monthly mortgage payments that increased by hundreds or even thousands of dollars. The federal government had to step in as both homeowners and businesses lost everything.
Those looking to buy a home find themselves facing the unpleasant combination of high interest rates for fixed-rate mortgage loans and an extremely limited inventory of available houses in many parts of the country. Perhaps that explains the rejuvenated interest in adjustable-rate loans, which have crept to over 10% of new loans for home purchases. Their current initial fixed-rate period, ranging between 5% and 6%, offers lower monthly payments than a traditional fixed-rate loan, but carries an element of risk for those who don’t plan to resell or refinance before the ARM interest rates can begin to fluctuate.
For most people, homebuying represents the most expensive purchase of their lives. Legislation was passed in the aftermath of the 2008 financial crisis to prevent another large-scale collapse of the housing market, but there are still risks associated with choosing an ARM loan as a mortgage option. Forewarned is forearmed. Having a firm grasp of how both types of mortgages work can allow you to make an educated decision on how to pay for your new home.
Not Interested in That Rate at All
Since few people have the full purchase price for a house at their disposal, most work with a lender to obtain a mortgage loan. The overwhelming majority of mortgages use a fixed interest rate, usually for either a 15- or 30-year term. While the monthly payment amount may rise due to property tax hikes, the interest rate for the life of the loan is locked in at the loan’s origination. Federal interest rate changes have no effect on a fixed-rate loan.
First appearing in the early 1990s, ARMs gained popularity when the interest rate for 30-year fixed-term mortgage loans topped 9%. In general, ARMs offer a lower interest rate than fixed-rate loans for a specified period, with most holding steady for either five, seven, or 10 years. After that, the interest rate increases or decreases in accordance with the federal interest rate.
If that sounds like a bit of a gamble, that’s because it is. While the lower initial interest rate is attractive, it’s common for those choosing this type of loan to view it as a short-term investment and refinancing once the ARM rate is no longer fixed. A carefully planned household budget is often not prepared for an increase of several hundred dollars a month due to increased interest payments.
To forestall a repeat of 2008, the Dodd-Frank Act of 2010 addressed several financial practices, including mortgage lending. In addition to targeting predatory mortgage lenders, the Act laid out guidelines to prevent banks and other financial institutions from offering borrowers loan options they couldn’t possibly meet. It also demanded clarity on loan terms, loan amounts, and potential annual percentage rates. What does that mean for an ARM mortgage?
Place Your Bets!
While certain aspects of Dodd-Frank have been weakened or whittled away since its passing, most of the mortgage protections regarding ARM loans remain in place. These include adjustable rate caps and more upfront information about the possible risks associated with an adjustable-rate mortgage loan, such as awareness that refinancing will involve substantial closing costs.
Prospective homeowners applying for an ARM loan will have to meet stricter qualifications than applicants seeking a fixed-rate mortgage loan, which is for their own protection. These requirements include higher credit scores, a lower debt-to-income ratio, and a more substantial down payment. An applicant is assessed on their ability to cover the higher monthly payments once the rate adjusts, not on the introductory rate. Being rejected for an ARM loan may sting at first, but it’s done to prevent a financial catastrophe down the road.
With the steps taken to prevent the tsunami of foreclosures that flooded the nation, opting for an adjustable-rate mortgage is far less perilous than it was. Unless you are certain that the funds for refinancing will be available when the initial fixed-rate period expires, leaving yourself open to the whims of the interest rates or the housing market is a risk. The protections mean there’s potential for notable savings by opting for an adjustable-rate mortgage loan, but it’s going to be a gamble.
Related Resources
- Homeowner’s Financial Worksheet (FindLaw’s Buying a Home)
- Qualifying for a Mortgage (FindLaw’s Mortgage and Equity Loan Laws)
- Mortgage Refinancing Do’s and Don’ts (FindLaw’s Debt Relief)
