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Updated:         June 4, 2018

During the past several years, fixed rate financing has been the most often selected form of home financing for most borrowers. With fixed rates continuing to hover just above 4%, they remain the popular financing choice. As the rate of property appreciation has moderated, homebuyers anticipate that they will likely remain in any newly purchased home rather than "move up" anytime soon. This may suggest that homeowners may stay in their homes for a longer period of time . . . perhaps eight or more years. Regardless of the "holding time", many homebuyers still prefer the comfort of knowing what their payment is going to be each and every month as is the case with fixed rate financing. On the other hand, when fixed interest rates increase, Adjustable Rate Mortgages (ARM's) often become a bit more popular. There are a few additional times when an ARM loan might make sense.

IF THE BORROWER CAN QUALIFY FOR A LARGER LOAN AMOUNT: While this may have been true several years ago, this may be more of a myth than reality in today's ARM market. In the past, a borrower actually "qualified" at the low ARM start rate which resulted in their being able to borrow more money and purchase a more expensive home. Most ARM products today, however, require a borrower to qualify at the "start rate plus 2%" or at the "fully indexed rate". The latter is the "index" plus the margin. (i.e.; we add the margin of 2.25% to an estimated LIBOR Index of 2.70% and the fully indexed/qualifying rate would be 4.95%). This "fully indexed rate" is at best usually only approximately .75% less than a comparable fixed rate and will hardly allow a borrower to qualify for much additional loan amount.

WHEN A BORROWER WANTS LOWER INITIAL PAYMENTS: An ARM with a very low start rate (i.e.; 1.75% to 2.5%) is more likely to have negative amortization than a higher start rate loan. These "Neg Am" loans can result in an erosion of one's equity. Typically, the borrower is provided the option each month to pay (1) either the minimum payment , (2) a higher payment that will, at least, pay all the interest, or (3) a payment amount that will fully amortize the loan. While the initial payment amount may be predicated on the initial low interest rate, the loan accrues interest at the fully indexed rate (described above), resulting in unpaid interest having to be added to the loan balance . . . this is the "negative amortization" or "deferred interest". As home appreciation rates remains minimal lenders are more reluctant to make this kind of loan where equity is eroded.

While these loans may be less popular than a few years ago when double digit appreciation more than equaled any negative amortization, this type of ARM "controls the loan's payments" as they increase a maximum of only 7.5% each year. Thus, for those who need to have a low monthly payment and need to know exactly the amount of each year's increase, these loans may be one answer. These loans are more likely to have pre-payment penalties assessed during the first three years of the loan. Depending upon the borrower's specific need for lower initial payments, the 30 due in 3, 5 or 7 year fixed rate might be an alternative to the ARM loan.

The negatively amortized loan is not readily found at present. But, there are efforts to re-introduce more flexible loan instruments and history does have way of repeating itself.

Be cautious of such financing.

WHEN THE BORROWER WANTS TO MAKE PRINCIPAL REDUCTION PAYMENTS: In those situations when a borrower desires to make significant principal reduction payments, the "no-neg" ARM loan (without a pre-payment penalty) may be appropriate as the payment will reduce according to the amount of the principal reduction at the loan's next adjustment date. This occurs most frequently when a buyer purchases prior to selling a current residence. The intent is to extract their equity upon the future sale of their residence and make a significant "principal pay down" payment on the new loan.

Adjustable Rate Mortgages remain available in today's mortgage market place albeit with lesser choices than in past years. There are times when an ARM makes perfect sense. When acquiring such financing, a borrower must be certain to understand all of the characteristics of the selected loan. It is important to avoid surprises after the loan process has been completed and it is too late to make adjustments to the loan terms.

New loan options are being advertised as non-QM loans, meaning they are not subject to the oversight of the Fannie Mae and Freddie Mac loans. These loans are more likely to offer adjustable rates (along with higher fixed rates) for those borrowers who have blemished credit or are, for other reasons, unable to qualify for more conventional or government loan options. 


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