Adjustable-Rate Mortgages in the Post-Boom Era
by Jason Dean
Adjustable-rate mortgages (ARMs) and other “alternative financing” or “non-traditional lending” products helped fuel the housing boom of 2001-2005, but now that the boom has turned to bust, ARMs have been given a bad name. Is this fair?
On one level, it is true that many mortgage lenders and Realtors knowingly set up clients with loans they didn’t understand or would be unable to repay once interest rates went up. But on the other hand, it is each individual’s personal responsibility to understand his or her own loan. The only responsibility the lender should have is to fully disclose all of the terms and make sure the borrower truly understands them.
When an ARM is the Smart Choice
An adjustable-rate mortgage can be a savvy choice if at least one of the following is true:
- You anticipate (with good reason) making more money in the future than you do now, and thus you’ll be able to handle the higher monthly payment once your rate adjusts.
- You are in a “hot market,” and you plan to refinance before the rate adjusts. You anticipate building up enough equity in the meantime that you’ll be able to get a lower monthly payment, even at a higher fixed rate.
Given these factors, taking out an ARM can be very financially savvy, but with each and every financial strategy comes risk. You, as a borrower, have to assume full responsibility for knowingly assuming that risk.
When an ARM is Not Right for You
You should not use an ARM if you fail to meet either of the criteria above, or, more specifically, if you’re only going with an ARM because you can’t afford or qualify for a traditional mortgage. When rates adjust upward, you will be paying more than you would under a fixed-rate mortgage, so if you don’t anticipate earning more money in the future, you’re going to have trouble making your monthly payments.
How and When do ARMs Adjust?
Every ARM is based on a market index. One of the most popular is the London Interbank Offered Rate (LIBOR), which is the rate charged by banks on unsecured loans to other banks. The terms of your mortgage will specify which index you use (LIBOR, prime rate, and the 10-year Treasury bond are popular examples), how much your rate will adjust to (i.e. LIBOR + 2%), when your rate will first adjust, and how often it will reset thereafter. It is vital for financially literate people to know and fully understand these terms!
ARMs can be wonderful tools for financially savvy consumers, and if you’re reading this blog, that probably means you! But with the Federal Reserve’s discount rate stuck at 6.25%, and no real sense of where interest rates are headed, ARMs have become less popular. Still, with all the negative press right now, it is important for people to appreciate ARMs for what they are: Financial products that, like all other pecuniary tools, are good for some people, and not-so-good for others. As with all things, it depends on your specific circumstances.