Variable rate mortgages have gotten a poor rap lately. They’ve been blamed with regard to contributing to the financial crisis, causing the mortgage mess we’re in, ruining the credit of millions of homeowners plus driving them from their homes. Yet can a piece of paper really lead to calamity?
The adjustable rate mortgage (most people call them ARMs for brevity) is no more dangerous towards the financial well-being of the country or even individuals than any other type of economic commitment. ARMs have been in use for many years. They offer tremendous flexibility when utilized 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 actually the “A” in ARM. You know that in a fixed interest mortgage like the traditional 30 year, the rate cannot change. If it begins at 4% it will always be 4%. The change side of this coin is that if the rate on a fixed mortgage can be 13%, it will always be 13%. Given that this article isn’t comparing mortgage sorts I’ve ignored the fact that a refinance can bring down the rate for now. To our ARM.
Because an ARM’s interest rate is adjustable we know that the interest rate on the mortgage can change. How much? Whenever? Why? The rate may increase or even decrease according to outside factors, that is, factors outside of the mortgage. Some Hands are linked to (sometimes called indexed) the rate being charged for an 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 home loan to sell them. All ARMs are usually linked to some outside factor, or even index. In our example, let’s say the ARM is tied to the ten year Treasury note. If the Treasury note rate increases from 5% to 6% then the interest rate around the ARM linked (indexed) to this Treasury note may increase. Don’t concern, protections are built in to the ARM to stop it from jumping up and down each week.
How do we protect our home loan payment from the unknown? Simple, the ARM has rules built in explaining how often the rate can change and how high it can go. When you talk to a mortgage lender about an ARM they are happy to fully explain all of these guidelines. 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 set just like the 30 year mortgage.
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Nothing can move it up or lower. So if the US Treasury department must raise interest rates to sell bonds it won’t affect our mortgage. No matter how higher the Treasury rates go. Simply doesn’t matter to us.
The following protection built in to our ARM is the increase cap. This caps or even limits the amount the interest rate can increase in a specific period. This period is normally 1 year. Let’s imagine we’ve been living in our house for 3 years and spending our mortgage note on time. The three 12 months period is over. And let’s more say our initial, or starting, rate was 4%. But in the 3 years since we obtained our own mortgage Treasury interest rates have increased to 11%. Wow! No problem for all of us. As our ARM limits the increase in our rate to 1. 5% a year. Again, no matter how high the pace 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? When 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 proceed from 4% to 10%, that will wouldn’t work. Fear not since the ARM has a lifetime cap as well. 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 transaction? Because, like many tools, the type of mortgage you get should depend upon your circumstances and your plans. Hammering a toenail is a pretty straightforward task, yet consider the various types of hammer you can buy. Just as different hammers meet different requirements, 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 more let’s define our terms. A genuine real estate investor is a businessperson. Real estate investing may be their full-time job, or they may have a day job is to 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 acknowledge 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 market the property they buy. But there is one thing a true investor possesses the fact that avereage ‘flipper’ doesn’t: knowledge. They know the market and usually earn. 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 traders. I could go on but that’s a various article. Let’s just assume that traders know what they’re doing.
So , exactly why would they want an ARM? Due to the fact money is a resource for them and they also believe they can get out of the property prior to 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 property investors often choose ARMs whenever they buy property.
Another type of buyer which may like the terms of an ARM is a person who will own a home for a foreseeable period of time. They may have got inherited a property from someone and want to take some cash out of it but have plans to sell it. Often buyers which work for large, international businesses such as ARMs. They know they won’t maintain an area for more than the period of the particular ARM protection (it may be 12 months, two years, anywhere up to 5 years). They reason that the lower rate on the ARM is better for them since they’ll be selling soon. What’s that you simply say? In this market houses may sell quickly and a lot of people who have to move can’t sell their homes. I agree. But each person’s situation is unique. The lower payment from the ARM early on may allow the proprietor to move and then rent the home and still come out OK when the rate increases.
Quick note on home marketing 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 promoting are almost always overpriced.
As you can see ARMs have a place in our mortgage financing economic climate. They aren’t for everyone, but nor is a Mercedes. Also, keep in mind that Hands should never be used to lower a transaction just so a buyer are able to 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 home loans or vacuum cleaners. Take the time to understand all of your options. Work with a professional you feel comfortable with plus trust. A true pro will look to you because it’s the right action to take. They also want your repeat business and they want you to refer your family and friends to them.