Risky Adjustable-Rate Mortgages Are Starting to Make a Big Comeback

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The dramatic rise in interest rates that has occurred over the past two months has had a big impact on the mortgage-loan market. Rates on standard 30-year mortgages have gone from below 3.5 percent as recently as late April to well above 4.5 percent currently, according to Bankrate, significantly increasing the monthly payments that new homebuyers will pay and making it harder to qualify for mortgage loans.

But there's one type of mortgage loan that hasn't seen interest rates budge: adjustable-rate mortgages. They're risky, and some blame them for the last housing bubble, but you can expect to see a big rise in the use of ARMs -- at what could be the worst possible time.

The Risks and Rewards of Adjustable-Rate Mortgages

Until recently, it didn't make sense for most would-be borrowers to look seriously at ARMs. With fixed-rate mortgages available at interest rates near or in some cases below those offered for ARMs, there was no substantial reward to make up for taking on the risk of frequent changes in the interest rate you'd pay on your loan.

Now, though, ARMs are the only way you can get a mortgage with a rate below 3 percent, and that's almost certain to make homebuyers who've missed out on low fixed-rate mortgages take a second look at adjustable-rate mortgages. Indeed, even as other mortgage rates have soared, ARM rates as reported by Bankrate have held steady between 2.7 percent and 3.1 percent. As Freddie Mac Vice President and Chief Economist Frank Nothaft observed recently, "with the ongoing run up in fixed mortgage rates, adjustable-rate mortgages are becoming more popular among homeowners looking to refinance and for home purchasers." Last week, the Mortgage Bankers Association said that the share of adjustable-rate mortgage activity rose to its highest level since July 2008.

The benefits of an adjustable-rate mortgage when fixed rates are relatively high are easy to see. With payments that are amortized over the same period as a 30-year fixed mortgage, monthly payments on ARMs can be much lower when there's a big gap in rates between fixed and adjustable mortgages. For instance, at 3 percent, your monthly payment on a $200,000 home would be $843. At 4 percent, the payment would be $955. Put another way, if your income only qualified you for a monthly payment of $843, then paying a higher rate would only allow you to take out a loan for $177,000. So having access to lower-rate ARMs will let you spend more on the house you want, which is useful especially in light of the increases in home prices over the past year.

The problem with ARMs, though, is that the interest rate is subject to change throughout the life of the loan. For the lowest-rate ARMs available, that initial low rate is locked in for only one year, with subsequent resets on an annual basis. If short-term interest rates start to follow longer-term rates higher, then your monthly payment will skyrocket. Other types of ARMs allow you to lock in the initial rate for a longer period of time, but they start with higher interest rates, too.

Be Careful With ARMs

Before you consider an adjustable-rate mortgage, you need to understand exactly what its terms mean and what effect they could have on your payments in the future. Look closely at provisions governing maximum rate increases both annually and over the life of your loan, and run the numbers to see how much your monthly payment would rise under a broad set of realistic scenarios. The short-term interest rates on which ARMs are based are still near record lows despite the run-up in other mortgage rates, but economists believe that eventually, those short-term rates will follow suit. If you don't want to make the same mistake that resulted in many borrowers losing their homes to foreclosure during the housing bust, then taking out an adjustable-rate mortgage without having the capacity to make payments in a more normal interest rate environment is a bad idea.

You can follow Motley Fool contributor Dan Caplinger on Twitter @DanCaplinger or on Google+.


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robert.beron

Rates have definitely helped keep real estate afloat. However, the real problems are unemployment, uncertainty, confidence in the economy, and tight mortgage lending standards.


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July 13 2013 at 3:55 AM Report abuse rate up rate down Reply
rschli7137

I've had an ARM since purchasing my home in 1992. It has consistantly been lower than traditional mortgages. I never calculated how much money I saved over the years, but it must be substantial. But, as the article states, know exactly what's in your agreement. Make sure there is no prepayment penalty. I only have a small balance left on my mortgage, so if for some reason the rates would skyrocket, I'd simply pay it off.

July 11 2013 at 2:03 PM Report abuse +1 rate up rate down Reply
1 reply to rschli7137's comment
vlady1000

I agree. I follow one simple rule, do not borrow more on a variable rate loan than you can pay off in 24-30 months, if you have to, should rates get out of hand.

July 11 2013 at 11:45 PM Report abuse rate up rate down Reply
h.hughjardon

Did a refi to am ARM in late 2009.....then got laid off (electrician). I was worried. I had planned on moving prior to the initial fixed rate expiring. Fortunatley, I did get back to work, and the interest rate has actually ticked down a couple of times.... so far so good.

July 11 2013 at 12:17 PM Report abuse -1 rate up rate down Reply
shurtcircuit

They way this system is ran is corrupt and I will no longer purchase large items including a house until there is reform.

July 11 2013 at 11:49 AM Report abuse +1 rate up rate down Reply
1 reply to shurtcircuit's comment
h.hughjardon

System? Which system?

July 11 2013 at 12:14 PM Report abuse -1 rate up rate down Reply
Wilson Boozer

Bigots love to blame the financial crisis on the CRA, but that is nonsense! Lenders inflated incomes to assure that the loans would be approved and sold the paper to financial institutions, that in turn bundled the loans and resold them to investors. Rating agencies gave the bundled loans investment quality ratings, joining in the fraud. Anyone who believes that the CRA is responsible is incapable of understanding the problem! Take a peek at “Inside Job,” or “Frontline-The Untouchables.”

July 11 2013 at 6:25 AM Report abuse +1 rate up rate down Reply
Keith

The liberal CRA; if it hadn't done enough damage to the housing market and the economy, democrats want an encore performance....

July 11 2013 at 12:54 AM Report abuse +1 rate up rate down Reply
toosmart4u

We cannot trust the bush era policies. He and the GOP tried to ruin this country. Did we learn our lesson? If you are drawing a social security check and on medicare thank a democrat, if you want to end these two programs vote republican.

July 10 2013 at 10:56 PM Report abuse -1 rate up rate down Reply
1 reply to toosmart4u's comment
h.hughjardon

Social security and medicare will end on their own, 2dumbforwords.

Exactly which bush policies are you talking about, simp?

July 11 2013 at 12:12 PM Report abuse -1 rate up rate down Reply
worried man

The big question is why did the interest rates suddenly almost double? nothing changed. Are they expecting millions of people to apply for ARMS? Or is this in anticipating 33 million visas being issued and they will all want homes? Or the illegals have enough money to buy homes ?

July 10 2013 at 10:29 PM Report abuse -1 rate up rate down Reply
2 replies to worried man's comment
vlady1000

Anticipation of Gov to cut back on stimulus (buying $90B of bonds/month). That is why all the long term bond yields have increased so sharply in the last 2 months and long term mort rates follow the long term bonds and hence the short term ARM's not moving up much. It appears this trend will continue, but the rate of increase should slow now.

July 10 2013 at 10:37 PM Report abuse rate up rate down Reply
1 reply to vlady1000's comment
vlady1000

But it can reverse overnight if enough bad news comes out that should make wall street think that our economy will be going backwards again. And, of course, if investors start to feel the stock market is too high and start moving $$ into bonds, and that will drive the yields (and mort rates) down some, but not a whole lot.

July 10 2013 at 10:42 PM Report abuse rate up rate down
rschli7137

Simple supply and demand. New housing is up (nearly 23% in my area over the last 2 years). Currently just in my township there are 73 new homes being built, 3 new developments being built with more than 155 singles and townhomes recently receiving township approval. The value of existing homes has risen 14% in the past 2 years. Interest rates have been held artificially low by the Fed. to induce home purchases. Obviously the time is coming where we're back to normal in the housing industry. My niece who is a realtor said business hasn't been this good since the collapse. She's making good money again. Unemployment has fallen to about 7.2% in my area. Construction is booming. Everywhere you look roads are being repaired/built, homes are being built, bridges are being repaired, etc.

July 11 2013 at 2:21 PM Report abuse rate up rate down Reply
Tom

Now we know why the housing industry is starting to make some movement upward. And guess what little ones...it's happening at a calculated timing rate to show how well the economy has progressed by the next general election. Very smart on someone's part (smile, wink, wink, nudge, nudge.)

July 10 2013 at 9:36 PM Report abuse -2 rate up rate down Reply
vlady1000

Have to agree with most the negative comments, but an ARM does work very well and can save money if used correctly in the situations where it makes sense . However, it should NOT be used as the instrument to get an applicant.qualified In fact, I feel you should have to be able to meet the qualifications of a 15Y to get an ARM. I have couple ARM's on a couple of my rentals, but there is 35% equity in the places, and they will be paid off in full in 3-4 years, so it made sense to go that way. But most ARM's should NOT be granted, they are used incorrectly by people that do not know how to use them.

July 10 2013 at 8:16 PM Report abuse +1 rate up rate down Reply
1 reply to vlady1000's comment
Keith

The ARM was never meant to "work correctly", it was developed and pushed purely for political reasons. Only a small percentage truly put it to work for financial stability.

July 11 2013 at 1:00 AM Report abuse +1 rate up rate down Reply