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   ARTICLE   |   From Scotsman Guide Residential Edition   |   August 2007

ARMs — Who Are They Good For?

Interest-only ARMs have gotten a bad rap lately, but they still could be a good option for some borrowers

Recent media coverage of the troubles in the nonprime mortgage business has made the public weary of these mortgage products. Indeed, the negative association is understandable considering some of the abuses that have recently become evident in the lending business. Lax lending policies and the practice of shoehorning homebuyers into properties they really could not afford have tainted the reputation of options like the interest-only ARM loan. But labeling interest-only ARMs as universally bad is much like throwing the baby out with the bath water.

Before you abandon this product, stop to consider a few things. ARMs still can be a good choice for many types of borrowers. If you take time to educate your clients and yourself about these products, you can continue to help your borrowers and find success.

Beyond the hype

Although interest rates are resetting, thus leading to rising delinquency and foreclosure rates, it is not the interest-only ARM itself that is the problem. Other factors — i.e., bad lending practices; unscrupulous lenders; a huge appetite for mortgage-backed-securities yields on the parts of insurance-company, hedge-fund and pension-fund investors; and programs aimed at increasing homeownership levels — have all contributed to the problem.

Some consumer-rights activists now claim that any loan product that has the potential to increase in cost over time can be bad for consumers. What they forget is that an ARM-loan payment also has the potential to decrease in cost if interest rates fall, something fixed-rate loans never do.

It is regrettable that so many people who should never have been offered interest-only and negatively amortizing ARMs were put into these products. Unfortunately, because many brokers don’t know how to sell ARMs and because the mainstream media is frightening away borrowers who could benefit from them, many homeowners never even consider an ARM loan of any kind. As a result, some American borrowers could unnecessarily spend billions in excess interest expense every year.

Benefits to borrowers

First, remember that the average mortgage in the United States has a life of less than seven years. Job transfers, changes in housing requirements, changes in homeowner income, cash-out refinancing and other factors can lead to sudden home sales and new mortgages. So putting clients in a 30-year, fixed-rate mortgage could cost some of them thousands of dollars more than the cost of an ARM over the life of their mortgage.

Second, an interest-only loan can be ideal for homebuyers who know they will only be in their home for a short period of time. For instance, borrowers who know their employers will transfer them to another location within three years gain little from taking out a fully amortizing loan. Historically, they would be better off selecting a three-year or five-year ARM over a loan with a longer fixed-rate term. Also, during the first three years of a mortgage, principal represents such a small portion of the monthly payment that it makes sense for many homeowners to use the principal component of their payment for maintenance, which can help make their home easier to sell.

Interest-only loans also can be beneficial for some borrowers who plan to be in their homes for longer than three years. Consider homebuyers who are recent college or graduate-school graduates and who have excellent prospects for advancement and salary increases in the near future. An interest-only ARM’s lower initial payments facilitate cash-flow requirements when these borrowers are just starting out and allow them to make principal payments as their incomes increase.

And then there are the savvy, experienced borrowers who perceive a mortgage as more than a mechanism for acquiring a home. Many homebuyers understand the investment opportunities inherent to buying a home with a 6-percent interest rate and investing the principal component in their own business or in other investments that gain greater interest. In general, the more-affluent, highly liquid borrowers are more likely to elect interest-only products and to opt to put down the minimum required down payment on their home purchases. As time goes on, these same borrowers are more likely to refinance their homes to pull out equity.

Other viable candidates for interest-only ARMs are borrowers who have erratic sources of income. Borrowers who depend on commission income that varies dramatically from month-to-month may find an interest-only ARM an attractive way to minimize their cash outflow. When their income is higher, they often elect to pay down principal. The same holds true for borrowers who receive quarterly or annual bonus incomes, especially those whose bonuses represent a significant portion of their total income. An interest-only ARM allows these borrowers to pay interest throughout the year and then to make a significant principal reduction at bonus time, if they so choose.

Investigate and educate

From a big-picture perspective, the mortgage industry is faced with a tremendous opportunity to give American homeowners the education and evaluation tools they need to make more-informed financial decisions. With today’s sophisticated ARM products, there is an even greater opportunity to advise borrowers effectively and to form strong relationships that lead to more referral business and to long-term customers.

Quite simply, today’s savvy homebuyers are hungry for information and options for making the most of their purchase and their mortgage. Investigate these products and learn how to sell them. This is a great opportunity for mortgage brokers who fully understand the power of the interest-only ARM loan.


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