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   ARTICLE   |   From Scotsman Guide Residential Edition   |   May 2017

The One-Two Punch to Rising Rates

Adjustable rate mortgages can win over skeptical borrowers with lower rates and higher security

r_2017-05_Marty_spotLike practically every other sector of the U.S. economy, the housing industry can expect significant changes in the face of new economic pressures this year. Two big topics defining the country’s financial news bear this out: We have a new president with a radically different agenda than his predecessor, and the Federal Reserve raised its key interest rate this past December and again this past March. In addition, the Fed has indicated that it plans to raise rates two more times this year.

These factors inevitably create a sense of doubt among borrowers, often encouraging a wait-and-see approach to refinancing or buying a new home. Hesitation and inaction carry their own risks when it comes to making one of life’s biggest decisions, however, especially in a changing economic landscape. That’s why some loan originators are educating borrowers on adjustable rate mortgages (ARMs). These can be a beneficial lending option for those who understand how they work.

You read that right: ARMs may be the antidote to borrower indecision during economic upheaval.

Relieving fears

Educating uneasy borrowers who have concerns about ARMs can be challenging for loan originators. Many borrowers will likely want to know how ARMs, seen by some as a contributor to the 2008 housing crisis, now represent a sound home-loan option.

The answer is simple: Today’s ARMs are not the same as the lending instruments that helped spark the recession. Many of those products had short initial fixed periods and high adjustment caps. Most ARM products today follow a standard adjustment cap of 5/2/5 with some offering a 2/2/5 cap structure.

The first number is how much the rate can change initially after the fixed-rate period ends. The second number is the cap on yearly changes after the initial change, and the third number is the lifetime cap. So, the interest rates on these ARMS can never increase more than 5 percent above the initial rate. Freddie Mac has reduced the initial payment cap to only 2 percent on the 5/1 ARM, down from 5 percent, substantially reducing the potential payment shock when the fixed-rate period of an ARM ends.

In addition, the riskiest of the ARM products are no longer prevalent, such as negative amortization products, reduced documentation, and loans with prepayment penalties. Interest-only ARM products are less common, but are still available to the most financially-savvy borrowers from some of the mortgage industry’s biggest players.

The benefits of the ARM products today are significant and varied:

  • Customizable terms. Even under unpredictable market conditions, ARMs provide customers stability during the initial fixed period of the loan, which typically lasts five, seven or 10 years. For homebuyers who know how long they will stay in their houses, an ARM could be a beneficial choice but it is always wise for borrowers to consult with a financial adviser to assess their short- and long-term financial goals
  • Lower rates. During the initial fixed period, ARMs typically have lower rates than comparable fixed-rate products, which can be a powerful way to quiet the sirens of alarmist headlines and soundbites that stoke consumer worry about rising rates.
  • More security. The option for borrowers to select lower initial rate-adjustment caps limits the amount the mortgage interest rate can change after the fixed period expires, making payment shock less of a concern.
  • Increased cash flow. Lower rates translate to lower monthly payments, freeing up cash for customers looking to save, invest or spend a little more each month. Demonstrating this feature with fixed-versus-ARM monthly-payment scenarios is an effective way to show borrowers the practical benefits of ARMs.

Selling benefits

Consider the lower monthly payment an ARM offers during the initial fixed-rate period, for example, and compare that to a fixed-rate product with the same term. For some people, this “found” money will be spent as discretionary income, go into a savings account or get integrated into other investments.

There are a number of life scenarios where ARMS
can be the best borrowing option.

For financially-savvy homebuyers and homeowners who understand the intricacies of how mortgages work, the ARM provides a structured opportunity to save a lot of money that can be used to pay down the loan more quickly. To demonstrate how a homebuyer could manage an ARM with this disciplined approach — basically paying down the ARM as if it were a comparable 30-year fixed product — consider the following scenario:

Say a borrower wants to buy a $350,000 home and has a 20 percent payment to put down ($70,000). With excellent credit and a 7/1 ARM at 3.625 percent this borrower pays about $1,277 per month for the first 84 months, which is $100 less per month than the roughly $1,377 the same borrower would pay on a 30-year fixed-rate mortgage at 4.25 percent. This translates to $8,400 the borrower can divert back to the mortgage principle before selling, refinancing or making payments in the adjustable period.

Another factor to discuss with borrowers is that mortgage rates on ARMs don’t necessarily go up after the fixed period expires. Rates are in no way obligated to climb after the adjustable period kicks in, because they depend on and react to market conditions and the availability of credit. In some cases, an ARM rate will adjust down instead of up.

It is true that mortgage rates are coming off historical lows and the U.S. economy is growing, however, so the probability of this contingency is not necessarily high, but a lot can happen in five years, which is the most common initial fixed term for ARMs.

People who have a definite future timeframe for staying in their home seemingly benefit the most from the features and structure of an ARM, but there are a number of life scenarios where ARMS can be the best borrowing option. Consider the middle-aged couple whose youngest child is a sophomore in high school, for example.

The home this couple lives in, once the bustling hub of an active family, will be empty in a few years and too big to maintain for two people who want to take their own next step in life. With a 5/1 ARM, this couple can refinance for a lower monthly payment, use the savings to buy college textbooks and supplies for their young scholar, and have five years to find a new, smaller home, before the ARM can adjust.

Consider also, professionals who are just starting out their careers. A young lawyer on track to make partner can use a 7/1 ARM to save money during the initial fixed period, and then sell and upgrade into a better place with the significantly bigger income that a partner commands.

•  •  •

Once seen as an instrument of crisis, the ARM has become a safer, more reliable home-loan option for diverse borrowers of different backgrounds and life situations. Although ARMs still carry risk, mortgage originators, as the experts borrowers turn to, must be there to educate their clients who are potentially concerned over rising interest rates. 


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