Once the darling of the mortgage industry, adjustable-rate mortgages are getting tougher to obtain. Savvy — and qualified — buyers, however, still may find them worth the hunt.
Adjustable-rate mortgages, known as ARMs, have been shouldering much of the blame for the housing crisis. In many cases it’s for good reason: The loans, which adjust periodically after a set introductory rate, carry greater risks than fixed-rate mortgages.
For an uneducated buyer, an ARM may be a recipe for financial trouble.
“There’s no question that an ARM can be a great tool for some, but a time bomb for others,” says Bob Moulton, president of the Americana Mortgage Group. In the past year, many who bought at the top edge of their budget got unwelcome payment increases of hundreds or thousands of dollars when rates adjusted at the end of the introductory period. Often, those soaring costs forced a homeowner into foreclosure.
The problem, says Scott Yonehiro, senior board member of First Security Lending, is that the ARM, once a niche product for a relatively small number of real estate investors and savvy homebuyers, became a product used by the masses. For many people, it’s simply the wrong tool for buying a home.
“Mortgages are similar to golf clubs in a golf bag,” he says. “You wouldn’t use a driver for an eight-foot putt, just as you wouldn’t use a 30-year fixed mortgage for a house you intend to live in for three years,” he says. “There’s no such thing as a bad mortgage — only bad loan officers who improperly suggest the wrong loan for a client.”
Tightening credit standards means that it’s tougher to get any loan at all — and that includes ARMs. Some of the riskiest products, such as one- and two-year ARMs with interest rates that spike after the introductory period, have been all but removed from mortgage lenders’ menu of options. But a wide range of ARMs are still available, ranging from 3/1 ARMs to 10/1 ARMs, as well as option ARMs. The interest rate on a 3/1 ARM would remain the same for the first three years and then adjust each years after that. A 10/1 ARM would hold the initial rate for the first 10 years. An option ARM permits borrowers to choose how they wish to make their payments each month: a traditional, fully amortizing payment; an interest-only payment; or a minimum monthly payment that is often not enough to cover the interest due.
And while ARMs still carry risks, it doesn’t mean you shouldn’t consider one if you want to buy a home. Educated and budget-savvy buyers in certain situations stand to reap significant financial benefits by using an ARM over a traditional fixed-rate mortgage. If you meet these guidelines, an ARM still may be right for you.
1. You’re good with your money
This is key, experts agree. If you know your way around a budget, live within your means and don’t get in over your head financially, you’ll probably be able to handle an ARM.
“If you’re someone who lives paycheck to paycheck and if you have a hard time managing your money, in general, you’re not going to be successful with an ARM,” says Yonehiro.
2. You don’t plan to stay in a house long
Young couples buying starter homes and executives who get transferred to new cities every few years are people who may benefit from an ARM. Still, Yonehiro recommends a conservative approach.
“If a client says they see themselves in a house for five years, I would recommend a seven or 10-year fixed period instead of five,” he says. “We know that sometimes life doesn’t always go as planned, and there might be setbacks. It’s always good to have an extra year or two of protection.”
3. You expect significant salary increases and bonuses
If you’re early in your career but your boss suggests you’ve got what it takes to climb the corporate ladder, you may opt for an ARM. The loan will give you low payments while you’re earning peanuts, but larger payments later on — presumably, when you’re raking in the dough. It may also be appropriate for families that have a stay-at-home mom or dad who will return to the workforce before the introductory period is over. Finally, an ARM can be a great tool for buyers who receive yearly bonuses or other large chunks of cash. Use that money to pay down the mortgage and you’ll benefit when the ARM resets, says Moulton. “The (new) calculation is based on the outstanding principal, so for people who use that money to prepay their mortgage, it can be a good option.”
4. You’ve looked beyond your personal finances
It’s often said that all real estate is local — so when you consider a risky product like an ARM, make sure you’ve done your homework to ensure that you won’t get stuck with a bad investment. Make sure you’re buying a home in a solid neighborhood.
“There are good parts and bad parts of every town, and those don’t change overnight,” says Ivan Fujihara, CEO of SIFF Investment Services. “Even in a recession, a good house in a good neighborhood can increase in value.”
While there are others who may be good candidates for ARMs — think real estate investors, speculators and wealthy individuals who want to use the extra cash to fund more lucrative investment vehicles — most of us don’t fit those categories.
The key, says Fujihara, is education. A close analysis of the market, your goals, and your finances should make it clear.
“The person who can most benefit from this type of loan is the person who understands the risks — and rewards — that ARMs provide,” he says.
ARMs for the times of our lives
Some stages of life lend themselves to ARMs more than others. Here’s a guide to see how you might fit.
|ARMs for different stages|
Consider an ARM?
Rationale, advice and cautions
|If you’re buying a first home or starter home that you expect to upgrade as you have children and earn promotions, you may benefit from an ARM with an introductory term that is a year or two longer than you expect to stay in the home.|
|Family with small children||
|If you’ve upsized to your dream home
|Family with teens/college-age children||
|An ARM can be a good choice for families who need every extra penny for college and retirement savings, and who will have extra cash once junior’s tuition bill has been paid off. It’s also beneficial for people who plan to own a home for only a few years before downsizing to a smaller place once the kids are out of the house. Be sure, however, that you’re willing to sell before the introductory term is up or be willing to sacrifice savings that may be better used for your golden years.|
|ARMs are rarely good choices for those living on a fixed income, as most retirees do. It may be tougher to weather sharp upticks in loan rates, so stick to a loan that has predictable payments for the long term.|