Will an ARM Loan Work For Your Clients?

While it’s the job of the mortgage professional to explain the ins and outs of adjustable rate mortgages (ARMs), it’s also important for real estate agents to understand how ARMs work and for whom.

Buyers are drawn to ARMs because the rates quoted in advertising are lower than fixed-rate mortgages. Most ARMs have a fixed-rate period at the beginning of the term, but after this initial period, the rate adjusts and could go significantly higher.

The terms of the mortgage determine how often the rate adjusts, how high the rate will ever be allowed to go, and how quickly it can increase.

An ARM’s interest rate is made up of the margin and the index. The margin, which is always fixed, is added to the index, which always has the potential to change.

The margin is set by the lender at the time the rate is locked. The index will be based on some economic indicator, such as treasury bills.

Once a year, or once every two years, the index is recalculated, and the interest rate that the buyer is being charged is adjusted.

In times of economic challenges, the indicators tend to be low, keeping the interest rate low. In a robust economy, when the indicators are increasing, so do buyers’ interest rates.

When you’re considering whether an ARM is appropriate for a particular client, be aware that qualifying for an adjustable rate mortgage is now more difficult than in the past.

After the mortgage meltdown, government regulators instituted Dodd-Frank, whereby lenders now require buyers to qualify for the fully indexed rate-a rate the mortgage could reach at some future point.

If, for example, the rate could increase to 11% at any point in time, the buyer must qualify for that mortgage as if the rate were 11% today. Buyers who are thinking short term-when the initial rate still applies and before the indexed portion kicks in-may be good candidates.

ARM lenders offer low rates initially, anticipating that rates will increase over time. If rates do increase, the buyer’s payments will also increase. But note that the buyer has initially had to qualify for his or her mortgage on the assumption that rates could rise to a certain level. So, is all well?

Not necessarily. The buyer may feel stretched making higher payments-maybe his or her situation has changed. So there are several options: Refinancing would be one.

If refinancing isn’t in the cards, he or she could make the higher payments until the home can be sold or the rates decline and the payment returns to a more manageable level.

Sadly, if it gets to the point where the buyer isn’t able to refinance, sell, or make the payment, they will default on the mortgage.

And, even if the borrower is able to refinance at a later date, he or she will undoubtedly be doing it at a rate that is higher than it was at the time they took out the initial mortgage.