| In March 2004, Federal Reserve Chairman Alan Greenspan was quoted in USA Today as saying that many homeowners could have saved thousands of dollars over the past decade if they had financed their homes with an adjustable-rate mortgage (ARM). Greenspan also stated, “American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage.”
What Greenspan suggested is indeed what the American consumer saw happen. Until recently an array of ARM products were available to consumers, each with unique benefits and terms. While these loans offered great flexibility, they have also resulted in fear and confusion among borrowers as the loans have begun to adjust.
Since the average life of a loan is seven years, three and five-year ARMs became very popular in recent years. Rates are set for an initial term and then adjust to the index plus a predetermined margin. These loans have caps on the adjustments and also lifetime caps and are either interest-only or amortized over thirty years. These loans are particularly advantageous for borrowers who invest the money that would have gone toward a higher mortgage payment.
Option ARMs also became widespread over the past five years. These loans had very low start rates, typically 1.0 percent. The minimum payment was set for one year and increased .75 percent the next year. After five years the payment would adjust to pay off the loan in 25 years. Each month, the borrower is given four payment options. If they choose to make only the minimum payment, the loan balance will increase by the amount of interest not paid on the loan, referred to as negative amortization. The loan is usually recast after five years or when the principal balance cap is reached (up to 110 percent-125 percent of the original balance depending on the loan terms).
The power in this type of loan is that if a borrower's income varies throughout the year they can make the lesser payment when money is tight and the higher payment when funds are available. Negative amortization loans have been an excellent financial tool for many sound borrowers with good credit. These loans were designed to create cash flow and provide opportunities for borrowers to invest their money in other ways.
The mortgage industry classifies borrowers by their ability to repay their loan, in an effort to control “risk.” The highest risk individuals are classified as “sub-prime” borrowers. Previously locked out home ownership, in recent years many of these borrowers became eligible for loans because interest rates were historically low, the credit markets were very liquid, and loan approval standards were relaxed. Lenders who specialized in sub-prime provided 100-125 percent financing to individuals with credit scores usually below 640 and income and assets were not always documented. Interest rates were normally much higher than for qualified borrowers and most had three-year pre-payment penalties. After the third year payments would readjust to a higher rate. The majority of these lenders have now gone out of business. As borrowers have not been able to make their payments, we have witnessed a negative chain reaction of foreclosures, credit freezing and economic down-turn.
With the confusion surrounding adjustable-rate mortgages and the downturn in the real estate market it is more important than ever that a borrower understand the terms of their loan and the options available. If you have an ARM, now is the time to review the terms of your note. Our message to you is… first, do not panic! There are still options available for current homeowners and investors with ARMs and people who want to get into the real estate market. Here are a few:
- The most straight forward approach is to re-finance out of an ARM into a loan with a lower fixed payment. However, when meeting with a mortgage consultant you may decide that you should not refinance immediately. Indexes have dropped over the past six months causing interest rates on some of the ARMs to be very attractive once again.
- You may consider contacting your current lender about modifying the terms of your existing loan.
- FHA loans are a lifeline available for distressed borrowers. Backed by the U.S government, the FHA Secure loan is a new refinance option that is being offered to homeowners that have fallen behind on their mortgage payments due to increasing interest rates and payments on their ARMs. In Kitsap County, FHA has increased the loan limit up to $475,000.
- The Veterans Administration (VA) Loan is a great option for qualified borrowers who have good credit for at least one year. VA borrowers can receive 100 percent financing.
- For real estate investors, now may be the time to increase rents or consider a 1031 exchange into a commercial property.
- An innovative product called the Home Ownership Accelerator has been growing in popularity. This loan allows borrowers to pay principal before interest, save thousands in interest, and instantly access their equity.
It is vitally important for you to visit a qualified mortgage consultant to determine all the options that are available to you.
(Editor’s Note: Carolyn Frame & David Beck are Certified Mortgage Planning Specialists with CFA Northwest Mortgage Professionals, an FHA direct lender. Reach them at 206-842-9347.)
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