Short Guide To Adjustable Rate Mortgages (ARMs)
With mortgage rates increasing, I have seen a lot of buyers deciding to go with an adjustable rate mortgage vs a fixed rate mortgage. Adjustable rate mortgages receive a bad public perception because of the 2008 housing crash, but the products I am going to discuss aren't the products back then and are vastly different. Although like any loan with an adjustable rate, there are risks to keep in mind. However, with the rising rates on a fixed mortgage, an adjustable rate can be a viable option and can save money in the long run. Another thing to keep in mind is that not all lenders may offer an ARM as a loan product. The ARM has four components: (1) an index, (2) a margin, (3) an interest rate cap structure, and (4) an initial interest rate period. Collectively, on how all four of those components factor out will help you make the decision on whether or not an ARM is a solid choice for your property purchase.
What is an Adjustable Rate Mortgage (ARM)?
With a fixed rate mortgage, the interest rate is locked in for the entire length of the loan, typically 15, 20 or 30 years. With an adjustable rate, the interest rate is locked for a set period of time, which is typically 5, 7 or 10 years but could vary. The rate is then adjustable depending on the which index the ARM is dependent upon for its rate. However, the ARM has interest rate cap structure so your rate can generally only rise so much in a given year and has a max rate for the life of the loan. The rate cap should come up in discussion with your lender on what the rate and payment could be for you on a "worse case scenario" so you know what the payment will be if you aren't able to refinance and have to have the ARM for longer than the fixed interest rate period. While fixed rate mortgages offer a fixed rate that will never change, there is some risk with an ARM because the rate changes depending on the index used for that loan product. However, depending on other factors, ARMS offer a lower initial interest rate that may outweigh the benefits of a fixed rate mortgage.
Why Choose An ARM Over A Fixed Rate Mortgage?
With interest rates on a fixed 30 year mortgage hovering at or around 5.5% today, an ARM can offer a rate for its fixed period lower than that around 4% depending on the fixed rate period of the loan product. So given life circumstances and what fixed rates are set at, an ARM could be a viable option. Below are some scenarios where an ARM may make sense.
Do you plan on moving soon or selling the home in a set period of time? If so, an ARM may make a lot of sense. If you planned on only staying in the house for five years or less, an ARM with a fixed rate for the first five or seven years would make sense. That way you take advantage of the low, fixed period and the home will be sold by the time the adjustable rate comes into effect.
Do you expect a bump in income or a new job with higher pay in the future? If so, an ARM can help you qualify easier because of a potentially higher debt-to-income but a lower monthly payment. When you do acquire that new job or increase in pay, you can always refinance to a fixed rate depending on what rates are at the current time. At that time, the principal will be lower, your debt-to-income ratio will be lower and you'll save money on interest by having the ARM!
Is the mortgage amount small and you expect to have the loan paid off by the expiration of the fixed term of the ARM? If so, you can save a bundle on interest and avoid the risk of a rate increase because the loan will be paid off by the time the rate could change.
Is the property you are buying an investment or rental property? If you are purchasing a property that you are rehabbing and reselling or having the property as a long-term rental property, an ARM may make sense. If you plan on rehabbing the property and reselling it in a short period of time, an ARM makes the more sense over a fixed rate mortgage. When a lender offers a fixed rate mortgage, they are taking the risk of rates not raising higher to lock you in at that rate for the term of the loan. However, with an ARM the lender is able to offer a lower rate because they are able to increase that rate at a later date when the fixed term of the ARM is over. In regards to rental properties, certain lenders are able to offer competitive rates with lower down payments than a fixed rate mortgage for rental properties because of flexibility in not having to adhere to Fannie Mae or Freddie Mac underwriting criteria. So ARMS are definitely worth venturing as an option if your property purchase is for a property you plan on flipping or holding as a long-term rental property.
Is the property you want to purchase a condominium? If you are looking at purchasing a condo as your primary home or as an investment, ARMs may be the right route to go. Fannie Mae and Freddie Mac underwriting criteria can be very extensive for condo purchases, making it more difficult to secure financing depending on the specific condominium association. Additionally, FHA loans can be very tough to get for a condominium purchase as well. "Non-warrantable" is a term used in real estate to describe a condo that does not meet conventional guidelines and will not be bought by government-backed entities like Fannie Mae and Freddie Mac. So depending on the condo association, an ARM could be a very viable option for a condo purchase. At R.L. Ventura & Associates, we have completed complex condominium purchases when so many lenders have told us no and found the buyer a great loan program with favorable terms.
Why Do ARMs Have A Bad Public Perception?
Many lenders during the early 2000's were offering ARMS to people who had no business getting a home loan in the first place. Loose lending guidelines and consumer misconception was rampant during these times. Many subprime lenders during that time enticed borrowers with interest-only ARMs that initially offered low rates. When rates began to soar, it created an affordability crisis that pushed many borrowers into foreclosure. This really created a negative stigma against ARMs as a terrible loan product that no consumer should ever consider. However, since the housing crash, lender underwriting standards have tightened and realistic rate caps have been put into place for ARMs. Additionally, lender transparency standards have been put into place since then, making foreclosure and unaffordability more unlikely for consumers. For example, one local lender I work with has a maximum annual rate adjustment on 1, 3 & 5 year set at 2% and a maximum of 6% increase over the life of the loan. In laymen's terms, this means your rate can only increase 2% in a one year period and 6% maximum over what the initial rate was during the fixed period. Understanding this is crucial and will be detailed out in your loan documents from your lender so you will know what your maximum monthly payment or the "worse case scenario" would be if rates skyrocketed at some point in time.
Is An ARM The Right Loan Product For You?
Getting a fixed rate mortgage or an ARM is dependent upon a lot of different factors discussed in this article. A key point to remember is working with a lender that offers both as an option if you think you may be interested in an ARM. A lender that is looking out for your best interest will be able to discuss your specific situation on the pros and cons of each, the effect on your debt-to-income ratio and what your long-term plan is with the purchase. Working with a real estate agent that is knowledageble about mortgage underwriting and not just real estate is also critical! A lot of agents know the real estate process very well, but understanding mortage underwriting is so crucial as well because if you can't get the loan, you can't get the house! At R.L. Ventura & Associates, we work with a variety of different lenders we can recommend to you given your situation and specific loan product you are looking for. Lenders aren't a "one size fits all" type of relationship and depend on the lender's experience working with different buyers and property types. If you are interested in becoming a homeowner, adding to your investment portfolio or thinking about getting into the house flipping business, contact us today! We are here to help be your guide on your property purchase.