Not too long ago, brokers and agents alike convinced many a financially naïve home buyer to buy a home he or she couldn’t afford on an interest-only ARM (adjustable rate mortgage). The idea was that in a short time, the property value would rise and the owner would thus magically acquire sufficient equity to qualify for a conventional loan on better terms.
Then came the housing market bust of 2006. Property values plummeted. When the introductory period of the interest-only ARM ended, the homeowner was left with an underwater mortgage and a new, higher monthly payment that he could not afford to pay. Many of these folks quickly lost their homes to foreclosure.
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What’s different about the ARM today?
The adjustable rate mortgage is still offered today, but with some differences. First of all, the interest-only ARM is nearly unheard of for everyday homebuyers, and is certainly not pushed and oversold the way it was in the past.
An adjustable rate mortgage is one in which the interest rate changes every so often (either every month, quarter, year, three years or five years), depending on the terms of the loan. ARMS become more attractive to borrowers when interest rates are high because they generally begin with a teaser rate that is lower than the going rate for conventional mortgages. Later, the interest rate goes up or down along with whatever index the rate is tied to. For borrowers interested in an ARM, it’s important to find out what index the rate will be tied to and its fluctuation history.
Like the interest-only ARM, the negative amortization ARM is enticing but dangerous. With this loan, the buyer gets a very low initial monthly payment. In fact, the payment only covers a portion of the interest and none of the principal at all. The unpaid interest is added to the principal balance and eventually the payment goes up significantly.
Is an ARM ever a good idea?
An ARM makes sense under certain circumstances, particularly if:
- You plan to sell the property within a few years
- You plan to pay off the entire mortgage within a few years (but not depending on rising property values at the mortgaged home)
- You expect to own the home for a long time and interest rates are currently very high (not the case at the present time). In this case, an ARM can get you into the home and allow you to wait for interest rates to go down. Then you refinance to a more affordable fixed rate mortgage.
In any case, talk to a qualified financial advisor about all of your options, including the worst-case scenarios for any given loan.
The Federal Reserve offers an informative free booklet for anyone considering an ARM.