Stong ARMs Are A Good Thing

Adjustable rate mortgages have gotten a bad rap lately. They've been blamed for contributing to the financial crisis, causing the mortgage mess we're in, ruining the credit of millions of homeowners and driving them from their homes. But can a piece of paper really lead to calamity?

The adjustable rate mortgage (most people call them ARMs for brevity) is no more dangerous to the financial well-being of the country or individuals than any other type of financial commitment. ARMs have been in use for many years. They offer tremendous flexibility when used properly. But they can't think for people.

ARMs aren't terribly complicated either, contrary to what the pundits would have you think. There are really only a few concepts you need to know.

First, ARMs are adjustable. This is the "A" in ARM. You know that in a fixed interest mortgage like the traditional 30 year, the rate can never change. If it begins at 4% it will always be 4%. The flip side of this coin is that if the rate on a fixed mortgage is 13%, it will always be 13%. Since this article isn't comparing mortgage types I've ignored the fact that a refinance can bring down the rate for now. Back to our ARM.

Because an ARM's interest rate is adjustable we know that the interest rate on the mortgage can change. How much? When? Why? The rate may increase or decrease according to outside factors, that is, factors outside of the mortgage. Some ARMs are linked to (sometimes called indexed) the rate being charged for a US government bond or bill. These bonds or bills change rates according to demand. If a lot of people want to buy Treasury bonds the government doesn't need to offer as high an interest rate to sell them. All ARMs are linked to some outside factor, or index. In our example, let's say the ARM is tied to the 10 year Treasury note. If the Treasury note rate increases from 5% to 6% then the interest rate on the ARM linked (indexed) to this Treasury note may increase. Don't fear, protections are built in to the ARM to stop it from jumping up and down every week.

How do we protect our mortgage payment from the unknown? Simple, the ARM has rules built in describing how often the rate can change and how high it can go. When you talk to a mortgage lender about an ARM they will be happy to fully explain all of these rules. Just ask!

The adjustable rate mortgage on our house is a 3/1 ARM, let's say. This means that the interest rate is fixed for the first 3 years of the mortgage. That's right, it's fixed just like the 30 year mortgage. Nothing can move it up or down. So if the US Treasury department needs to raise interest rates to sell bonds it won't affect our mortgage. No matter how high the Treasury rates go. Just doesn't matter to us.

The next protection built in to our ARM is the increase cap. This caps or limits the amount the interest rate can increase in a specific period. This period is usually 1 year. Let's imagine we've been living in our house for 3 years and paying our mortgage note on time. The three year period is over. And let's further say our initial, or beginning, rate was 4%. But in the 3 years since we obtained our mortgage Treasury interest rates have gone up to 11%. Wow! No problem for us. As our ARM limits the increase in our rate to 1.5% a year. Again, no matter how high the rate or number (index) our ARM is linked to may go, it can't move for the first 3 years. Then it can only move one time per year a maximum of 1.5%. Do you like the idea of your mortgage rate decreasing? If the index the mortgage interest rate is pegged to decreases, your rate comes down!

But what if the rates just keep on climbing? You could go from 4% to 10%, that wouldn't work. Fear not because the ARM has a lifetime cap too. If the lifetime cap is 7%, your rate can never go above 7%, no matter how high the index (the outside rate our interest rate is linked to) may go.

Now your're thinking. Well, it might only be a 1.5% increase but that's still an increase in my payment. You're right. So why would anyone want a mortgage that can increase your payment? Because, like many tools, the kind of mortgage you get should depend upon your situation and your plans. Hammering a nail is a pretty straightforward task, yet consider the various types of hammer you can buy. Just as different hammers meet different needs, different mortgages work best in different situations. Many people realize that an adustable rate mortgage suits them just fine.

Investors like ARMs. I mean real estate investors. Before we go any further let's define our terms. A true real estate investor is a businessperson. Real estate investing may be their full-time job, or they may have a day job and do real estate on the side. That said, they treat it like a business. They understand the risks that real estate investment pose and they accept them. The money they invest is money they can afford to lose. They are not people who are merely into 'flipping houses' although an investor may sell the property they buy. But there is one thing a true investor possesses that the avereage 'flipper' doesn't: knowledge. They know the market and usually win. We all know about the recent real estate bubble and how it was driven by 'flippers' and easy credit. I submit that most of these people were not real estate investors. I could go on but that's a different article. Let's just assume that investors know what they're doing.

So, why would they want an ARM? Because money is a resource for them and they believe they can get out of the property before the adjustment occurs. Perhaps they just want the lower payment that the ARM offers, confident they'll refinance before the protection period expires. Either way real estate investors often choose ARMs when they buy property.

Another type of buyer who may like the terms of an ARM is a person who will own a home for a foreseeable period of time. They may have inherited a property from someone and want to take some cash out of it but have plans to sell it. Often buyers who work for large, international businesses like ARMs. They know they won't be in an area for more than the period of the ARM protection (it may be one year, two years, anywhere up to 5 years). They reason that the lower rate on the ARM is better for them as they'll be selling soon. What's that you say? In this market houses don't sell quickly and a lot of people who need to move can't sell their houses. I agree. But each person's situation is unique. The lower payment of the ARM early on may allow the owner to move and then rent the home and still come out OK when the rate increases.

Quick note on home selling times. In most major cities the real estate market is pretty healthy. In some cities the market never slowed. Another thing to keep in mind is that homes that aren't selling are almost always overpriced.

As you can see ARMs have a place in our mortgage financing economy. They aren't for everyone, but neither is a Mercedes. Also, keep in mind that ARMs should never be used to lower a payment just so a buyer can afford the property. This is a recipe for disaster as many people can tell you today.

In the long run knowing the details makes all the difference. Doesn't matter if it's home mortgages or vacuum cleaners. Take the time to understand all of your options. Work with a professional you feel comfortable with and trust. A true pro will look out for you because it's the right thing to do. They also want your repeat business and they want you to refer your friends and family to them.

One more thing. When buying or selling property always use a Realtor. Realtors will protect your interest.

If you'd like to know more about adustable rate mortgages, other types of financing or are thinking about homes or condos in the Myrtle Beach area I'd like to hear from you. You can visit my website here. Other articles like this one on many real estate topics including market activity in Myrtle Beach can be found there.