Remember how adjustable rate mortgages (ARMs) were all the rage when the housing market was a boom town? Especially the more exotic ones, like interest-only and payment- option ARMs? Well, now that the housing market looks more like a ghost town, are ARMs still a good idea, or is being ARMed a dangerous place to be?
A short ARM review
Unlike a mortgage with an interest rate that’s fixed for the term of the loan, an ARM has an adjustable interest rate that’s tied to a published interest rate index. The index, plus a margin set by the lender, will determine the interest rate charged on your mortgage’s principal balance. At periodic intervals (often annually), the interest rate will be adjusted, up or down, in response to changes in the index.
ARMs also have interest rate caps. The periodic adjustment cap limits the amount the interest rate can fluctuate from one adjustment period to another; the lifetime cap limits the total increase in the interest rate over the life of the loan.
The allure of exotic ARMs
Some ARMs, particularly payment-option ARMs, include payment caps that limit the amount your monthly payment may increase at the time of each periodic adjustment. If the increase in the loan’s interest rate would make the monthly payment higher than the payment cap increase allows, the payment cap limits the monthly payment increase–and the difference (unpaid interest) is added each month to the principal balance due. This can lead to negative amortization, which is when your loan balance gets larger.
Payment-option ARMs also offer the alluring choice of a fixed monthly payment (for a specified period) that’s often less than the amount of the monthly interest charge, guaranteeing negative amortization on the loan from the beginning. The allure of this is the initial low payment. In the past few years, many people were lured into taking these mortgages, often to buy more house than they could ultimately afford, thinking they could refinance once the expanding equity in the property gave them room to do so.
But that allure doesn’t last forever. At some point (as of a specified date or when the negatively amortizing principal due reaches a certain percentage above what was originally borrowed), the loan is “recast.” At that point, the loan must be scheduled to amortize both principal and interest (at the specified rate as of the recalculation) over the remaining term of the loan, and any payment caps that have been in place no longer apply.
As a result, the monthly payment may well increase dramatically. If (as has recently proven to be the case) the borrower’s equity hasn’t increased as hoped, refinancing may be an impossibility, and what was once alluring may become dangerous.
Should you disARM?
Not necessarily. If you have an ARM that’s now fully amortizing both principal and interest, then you may be in good shape–for now. Conventional wisdom indicates that the risk associated with having an ARM occurs when interest rates are rising. But the rates for ARMs are currently low, and are traditionally lower than comparable fixed-rate mortgages. So you may want to stay with the ARM you have for the moment.
But if you are in an interest-only or paymentoption ARM, you may want to get out of it before the loan recasts–especially if your payment- option ARM is negatively amortizing. If you still have equity in your property, conventional refinancing may be an option for you. But if that’s not the case, contact your mortgage servicer about any restructuring opportunities available to you.
Homeowners with current Fannie Mae or Freddie Mac mortgages may be able to take advantage of the Making Home Affordable Refinancing plan; those with delinquent mortgages may qualify under the Modification plan. The new mortgage balance cannot exceed 105% of the home’s current value and must be under $729,750. Call (888) 995- HOPE for more information, or visit www.makinghomeaffordable.gov.
If your lender agrees to write down your Federal Housing Administration (FHA) insured mortgage’s balance to the current value of the property, the HOPE for Homeowners program may help you. The new loan you obtain can be no more than 96.5% of your home’s current value, and the loan limit is $550,440. Visit www.hud.gov for more information, or call (800) 225-5432.
