Despite bad rap, adjustable loans serve vital niche
Despite bad rap, adjustable loans serve vital niche
By November 2009, the share of the home-loan market flowing to adjustable-rate mortgages (ARMs) had slipped below 6 percent. In a sense, this venerable product that has been with us for decades has almost disappeared from the marketplace. And that's a shame, because the basic ARM is a useful and efficient alternative to fixed-rate mortgages.
The problem for ARMs is that the financial services industry almost engineered the ARM into oblivion, creating numerous, obscure, high-risk products for consumers such as interest-only ARMs and option ARMs, both of which involved a formidable amount of payment shock.
Seemingly congenial, the interest-only ARM, as an example, allowed the consumer to initially pay just the interest and not the principal. Wow, what a break for the borrower, right?
Not really, because the mortgage continued to amortize, which meant that at the end of the interest-only period, payments increased substantially. Since interest-only ARMs and their brethren were often sold to consumers with income or credit deficiencies, when the payments reset it was almost a certainty the borrower would not be able to afford the terms.
"ARMs are not evil," asserts Keith Gumbinger, vice president of HSH Associates, a Pompton Plains, N.J., mortgage rate tracking firm. "The traditional ARM has well-demonstrated and well-understood risk. It's when you get into exotic payment methodologies where you are making payments that don't even cover the interest that things go badly. The problem isn't the ARM -- it is the payment structure which is overlaid on top that helps the borrower dig a deeper and deeper hole."
As a result of these engineered ARMs and the problems they have wrought, all ARMs, even the basic product, have been tarred.
"It has gotten to the point, where consumers, looking at ARMs, consider it toxic," says Gumbinger. "It is like touching the third rail of mortgage lending."
All this is unfortunate because ARMs are strategically useful to some consumers. The attraction with the ARM was a lower interest rate for the first, mostly five years. Then, there was a reset. Before 2007, most homeowners with an ARM usually refinanced to a fixed-rate mortgage before the resetting of the ARM to higher interest rates, or they moved to a new property.
"If you have a fixed horizon -- that is, if you know you are moving in five years, seven years or 10 years because of the particular stage of life you are in -- child going to college or for business purposes -- the ARM is a good product," says Neil Sullivan, president of Westfield Mortgage LLC in Westfield, N.J.
Let's say a family has three children under 3 and one of the parents has landed an excellent job. At the moment, the family could afford only a starter home, but the mother and father know that in a couple of years they will need to move to a bigger house.
In that circumstance, says Sullivan, "there's no reason why they should have to pay a traditional amortization of 30 years. The family could use the extra money in the first five years, and they don't need to pay the cost of having the fixed-rate option for years six through 30."
About mid-year 2009, some of the homebuilders such as Toll Brothers Inc. decided to revive the ARM with a product that offered borrowers an interest rate of 3.75 percent for seven years. There was also a lifetime cap of 8.75 percent. In other words, after the reset, no matter what interest rates were at the time, the rate on this loan would not climb above 8.75 percent. No word on how effective the ARMs were in generating new business, but Toll Brothers' fourth-quarter net signed contracts were above levels of the same period in 2008.
That 3.75 percent looked awfully good, as the rate on the 30-year fixed was at least a full point higher at the time -- and that didn't make it a teaser rate.
"Today, with an ARM, you have an attractive interest rate," says Gumbinger. "The interesting thing is, you hear that these are teaser rates -- an artificially low interest rate designed to trick the borrower into taking an ARM. Technically, the phrase 'teaser rate' does have a definition: an interest rate that is below the value of the index that governs it. The introductory rate on ARMs are not teaser rates, and in many cases they are as high as the fully indexed rate or the sum of the index plus margin."
Today, if a consumer does find an ARM with a 3.75 percent introductory rate, as with the Toll Brothers loan, there is generally a cap of no more than 8.5 percent to 8.75 percent, which is not only reasonable but for many who are of baby boomer age something that was once the norm in their early homebuying years.
For the past two years, the mortgage market has been heavily weighted toward the traditional 30-year, fixed-rate product. That was to be expected, as there was a definite fallout from the exotic mortgage products that trapped millions in unfortunate and unaffordable payment situations.
Also, anyone buying a home in the past two years was probably looking for a more secure situation, and the 30-year, fixed-rate mortgage is our financial version of comfort food.
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