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Avoiding mortgage pitfalls: Adjustable rate mortgages

Dan Thomas • Apr 13, 2007 at 9:03 AM

There has been a great deal of ink spilled and a lot of discussion of late in the news about the serious problems in the mortgage industry. Many wholesale lenders have gone out of business since December and there has been a general rise in foreclosures in the past few months.

The issue as to why this has been happening is more complicated than generally reported and instead of finding fault, a better approach is to learn to avoid mortgage pitfalls.

A popular loan program is an adjustable rate mortgage or, ARM. These programs generally have less risk to the lender and have a lower interest rate as a result. ARMs allow a person who expects his or her income to rise to purchase a home at a lower payment. These have also been used by individuals with risky credit histories to purchase a home at a lower monthly payment. If ARMs are understood properly they can be a great asset. For example, I had a credit-challenged couple two years ago who could not qualify for a low fixed-rate loan. I laid out a plan by which they would be able to purchase the new home with an ARM program and work on repairing their credit over a two-year period. They followed the plan to the letter and I am now refinancing them at a very low fixed rate.

A standard ARM will have a fixed period of two, three, five or more years. Afterwards, they may adjust. Some ARMs are tied to indexes that do not normally fluctuate by very much and thus, the rate does not change. Others are tied to indexes that change more frequently and these ARMs will adjust after the fixed period is over. The first pitfall to avoid with these types of loans is failure to plan to refinance them. If a person plans to sell his or her home in two to three years, then keeping an ARM may make sense. However, it is important for a person who plans to keep his or her home and who has credit issues to have a plan that is followed to repair that credit over time so that they will be able to refinance before their payment increases.

A popular ARM is an Option ARM. In this type of program a person has an option of which payment he or she wishes to make. For example, a person may have a loan that would normally have a payment based on an interest rate of 6 percent. With the Option ARM he may select to make the payment based on 1.25 percent. This enables a person who expects his income to rise significantly over a year or so, such as a new doctor or lawyer, to afford a house that is beyond his or her present means, but not his or her future means. This type of borrower will be able to make the normally larger monthly payments at this future time. The danger with this type of loan is that a house may lose value and if he or she is only making minimum payments the homeowner may find the amount owed on the house is suddenly more than the house is worth. This happens in automobile financing frequently where a person is "upside down" on his vehicle because the amount owed is more than the value of the vehicle. This program is not suited for most borrowers and probably should be avoided by most.

Interest only ARMs are available that not only give a person a lower interest rate initially, but a lower house payment. As an example, a house purchased at 7 percent interest over 30 years would have a payment of $665 per month for two years. The interest only option makes this monthly payment only $583. The tax benefit is that the entire house payment may be deductible. This type of loan may be good for a person who plans to sell his or her house in a short time, say two years. However, continually using such a loan to stretch a housing budget is a pitfall best avoided.

Additionally, a person possibly could end up in the above mentioned negative amortization and be "upside down" on their home.

Many adjustable rate mortgage loans, especially sub-prime loans, have pre-payment penalties. If the loan is refinanced in this period of time, the lender charges a monetary penalty, such as 5 percent of the unpaid principle. On sub-prime loans, this may not be avoidable. However, a pitfall to avoid is any ARM loan whose pre-payment penalty is more than the fixed period of the loan.

For example, Jack and Sue have a two-year ARM, that is, a loan with a fixed interest and payment for two years. Jack and Sue should be able to refinance without a penalty at the end of those two years and not have to wait an additional year or more, making higher payments because of a pre-payment penalty. Avoid any pre-payment penalty if possible but avoid these lengthy pre-payment penalties, period.

Adjustable rate mortgages are not the devil in disguise they are frequently made out to be. However, with a bit of careful thought and planning, these valuable programs can be made to work for a great many people as long as they are careful to avoid the pitfalls that can occur.

Look for avoiding mortgage scams in the next installment of this series.

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