Mortgage consultant Peter Boutell writes that borrowers assume the risk when they take on an ARM.
You’ve probably heard about balloon payments. If you haven’t paid off your loan by a certain date (after three to five years), you’ll have to pay the balance in full or be foreclosed on.
Most ARMs are for 30 years.
The most famous subprime loans typically jumped the interest rate from three to five percentage points after the first three years of a loan.
Banks used margins of 2-3 percentage points on prime loans (to borrowers with great credit) and about 5 points for subprime borrowers.
When lending was easy, borrowers refinanced after three years to avoid this penalty.
Then the credit crisis hit in 2007 and refinancing became much more difficult.
Despite the Federal Reserve’s rate cuts, the rate on fixed rate 30-year loan remains over six percent.
The most dangerous of all loans is one that has a balloon payment. That means that at the end of the term of the loan may be just three to five years, there would still be a balance due and unless it is all paid by then, the lender will foreclose and take back the property. Fortunately, we do not see many of these loans because most loans are written with 30-year terms.
The now-notorious subprime loans typically offered a 30-year ARM that was fixed for just the first two or three years, after which the rate would be automatically jumping up by 3 or more percent. This was due to the fact that the notes called for margins often in excess of 5 percent while margins for prime loans were in the 2-3 percent range. The intention of the lenders that created these products was to make sure the borrowers refinanced out of them after that initial period was over. As we all have either heard about or experienced, these loans proved to be extremely dangerous in a declining real estate market because borrowers either never had equity or lost what little equity they did have and therefore there was no way to refinance out of them.
On the prime side, one of the most popular ARMs is a 30-year loan that has a fixed rate period of five or seven years, followed by a period of adjusting rates for the remainder of the 30-year term. These are referred to as hybrid mortgages because they are a mix of fixed rates and adjusting rates. Lenders have been able to entice borrowers into these loans because they offered rates that were initially 1 percent or more below the 30-year fixed rates.
The concern of any ARM is that at the end of the fixed-rate term the rates could go up if the underlying index value goes up and the borrower will then be faced with increased payments or the need to refinance. However, unlike the subprime loans, these loans carry margins typically under 3 percent and here’s the good news for those holding the best adjustable rate mortgages that are scheduled to be adjusting this year: Some of these ARMs may actually be adjusting down, not up, and those that are adjusting up may only be adjusting slightly. The reason is that the current underlying rates of most of the indexes are down from where they were five and seven years ago.
For example, the one-year treasury is below 2 percent and the one-month LIBOR index is below 3 percent. While there may be no immediate need to refinance right now, once the economy starts gearing up again, the Fed will start raising rates, which will put upward pressure on ARM indexes, and then borrowers with ARMs will want to be looking at refinancing.
Another consideration to keep in mind is that 30-year fixed-interest rates for loans under $417,000 have been hovering under 6 percent, which is historically low; however, fixed rates for loans above $417,000 have been higher than they should be due to the lack of liquidity in mortgage-backed securities. Fannie Mae just announced this week that rates for the newly created category of loans called "jumbo conforming" loan amounts between $417,000 to $729,750 would be coming more in line with rates under $417,000. This is great news for all those who now have loan amounts under $729,750 and have been waiting for lower rates.
Whether or not it is best for you to refinance now or not is dependent on many factors that would be best discussed with a mortgage professional who can analyze your existing mortgage and is both knowledgeable and able to provide a full array of mortgage options.
Peter Boutell is a mortgage consultant with a local mortgage company. Send questions to ‘Lending a Hand,’ 1535 Seabright Ave., Santa Cruz, CA 95062 or fax 425-1044. E-mail may be sent to Peter@SantaCruzHomeFinance.com. Archived columns are available at www.peterboutell.com.
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