The housing needs of Paul and Michelle Shilli will be changing once their first baby arrives, which is expected to be soon. So when the Bolingbrook couple refinanced recently, they decided on a mortgage that was changeable, too.
“We don’t have a basement in this house, and we won’t be here for more than two more years,” says Michelle. That’s why they selected a one-year adjustable rate mortgage (ARM), which changes rate once a year according to market conditions.
Because borrowers assume the risk of the mortgage rate rising up to 2 percentage points each year, ARMs offer lower interest rates for the initial year than do fixed-rate mortgages.
“We are paying 5 percent on the ARM and our payments went down $300 a month,” says Michelle. Their old rate was 8.75 percent. “The interest rate on this mortgage can go up 2 percent a year, but even if that happens, we will be better off for the length of time we will be in this house than if we had taken a fixed-rate mortgage at 7 percent.”
The Shillis’ choice of a mortgage that adjusts every year, the traditional ARM, is unusual in today’s environment. For the last couple of years, interest rates on fixed-rate mortgages have been in the single digits.
Most home buyers and refinancers are eagerly acquiring the fixed-rate loans, a comparative bargain after the lofty double-digit fixed rates of the 1980s and late 1970s. Even with ARMs marketed like blue-plate specials, with rates that sound more like the interest offered on passbook saving accounts, most mortgage seekers are snubbing the loans.
It’s not that ARMs are truly like bargain basement offerings, carrying the risk of shoddy quality. Mortgages are intangible products, and an ARM will allow you to buy a home as surely as a fixed-rate loan will. Although there have been servicing problems with ARMs (more on that later), there’s no difference in the way you pay your monthly mortgage bill.
The only key difference between an ARM and a fixed-rate is that the interest rate can fluctuate with the former, and the rate is locked in for the term of the loan with the latter.
“Even with initial interest rates as tantalizing as 3 percent,” notes Keith Gumbinger, media coordinator for the Butler, N.J., mortgage data firm HSH Associates, “most people are pretty savvy and they suspect that there is only one direction for the interest rate on ARMs to go-up.”
Still, it can pay to take the gamble if you’re only planning to be in your home for a certain length of time, like the Shillis are.
And although lenders look to see that your income is sufficient to cover payments after a rate rise, first-time or cash-strapped home buyers also can have sound reasons for selecting an ARM.
Short-term bet
While only a small proportion of mortgage seekers nationwide are opting for adjustable rate loans, Shari Butt, processing supervisor at Firstar Home Mortgage, Naperville, says that about 75 percent of the mortgage business at her office is in adjustables. That’s because Naperville is noted for having a constant influx of transferees, who plan to stay in the area for just a few years. Anyone who knows they will be in their home for the short haul is a perfect candidate for an ARM.
“We work out the math for our clients to see if they’d be better off with an adjustable or a fixed,” says Butt. The math is fairly simple: Take the starting rate on the ARM and add the maximum rate possible for each of the following years that you plan to stay in the home. Compare the average of that sum to the rates on 30-year fixed-rate loans, or other fixed-rate loan products.
For example, if an ARM is offered with a starting rate of 4.5 percent, and rate rises are limited to 2 percentage points annually with no more than a 6 point rise from the starting rate over the life of the loan, you would add 4.5 percent, 6.5 percent and so on. If you plan to stay in your home four years the average rate would be the sum of 4.5, 6.5, 8.5 and 10.5 divided by four. That would equal 7.5.
That is, even if the rate on the ARM was adjusted to the maximum level each year, you’d be paying an average of 7.5 percent. You’d have to find a fixed-rate loan under 7.5 percent to beat that scenario.
The traditional one-year adjustable has a cap on the annual rate rise of 2 percentage points, and a 6 point cap on rises throughout the life of the loan.
Lenders base rises on an index that closely matches market interest rate movements. In the Midwest, many lenders use the rate on one-year Treasury bills as the index, and fix a “margin” of about 2.75 percent that is added to that index to determine the adjusted rate, explains Dale Merrick, branch manager of TCF Mortgage in Arlington Heights.
In addition to the one-year Treasury bill index, some lenders use the six month T-bill rate, or a “cost-of-funds” index provided by banking regulators that measures the average of what savings banks and other financial institutions are paying their depositors.
Brian Moloney, vice president of Consumer Loan Advocates, a non-profit Lake Bluff firm that monitors ARMs, says that the six-month T-bill rate is the lowest index, but that the cost-of-funds index is probably the least volatile. Lenders use margins anywhere between 2 and 3 percent, says Moloney, and the lower margins tend to be coupled with higher indexes.
Mortgage seekers can compare rates by asking lenders for specifics on the indexes and margins used. By law, borrowers also must be given a consumer guide to ARMs published by the U.S. Department of Housing and Urban Development.
Purchasing power
With ads touting ARMs at initial rates of 3, 4 and 5 percent, it’s tempting to muse about how big a mortgage you could swing at those interest rate levels. But lenders, and the agencies that buy the mortgages from them, don’t want borrowers to be cash-squeezed when and if the interest rate adjusts upward.
That’s why, explains Ron Lapins, area manager of Commonwealth United Mortgage, Libertyville, lenders require any borrower making a down payment of 20 percent or less to qualify for the ARM at 7 percent, or the highest possible rate during the second year, whichever is higher.
That would mean that if you take an ARM with an initial starting rate of 5.5 percent, you must qualify for the loan as if it carried a rate of 7.5 percent. “Individual lenders may have slight differences in how they qualify borrowers for ARMs,” says Lapins. “But that’s the general rule.”
For borrowers who make down payments above 20 percent, lenders are more lenient in qualifying them at the initial rate, says Lapins.
Because of the qualifying rules, an ARM probably won’t help a first-time buyer who’s struggling to scrape together a down payment and who’s worried about having enough monthly income to qualify for as big a mortgage as he or she needs.
Lenders use the rule of thumb that the amount you pay in mortgage and real estate taxes shouldn’t exceed 28 percent of your gross income and that your mortgage and other monthly debts shouldn’t exceed 36 percent of your gross pay.
But Lapins says that many first-time buyers do find that FHA-insured ARMs help them stretch their purchasing power. With an FHA ARM, buyers are qualified at the first-year rate, says Judith Heaney, chief of the single-family development branch of the Chicago office of the U.S. Department of Housing and Urban Development. Not only is qualifying easier, but FHA one-year adjustables are limited to rate rises of just 1 percentage point each year, with a 5 percent lifetime rate-rise cap. FHA loans are limited to $151,725, says Heaney, with a 5 percent down payment required for mortgage amounts between $25,000 and $100,000, and a 10 percent down payment for amounts over $100,000.
Veterans Adminstration (VA) ARMs also are limited to a 1 percentage point rate rise each year, and have a 5 percentage point lifetime cap, says James Kimble, chief of loan processing for the Department of Veterans Affairs. But VA borrowers must qualify at the second-year rate.
The one-year FHA adjustable was the right choice for Lake Villa residents Andy and Debbi Wysocki, when they bought their first home last December. “The rate on the ARM was about 1.5 percent lower than the rate on fixed rates,” relates Andy. “We plan to be in this house no more than seven years. With rate rises limited to just 1 percent per year, we will do just about as well as with a fixed rate, and we are saving a lot the first couple of years.”
Varieties
The one-year ARM is the standard, but lenders have fashioned a whole host of ARMs to fit the pocketbook and plans of various buyers.
Some ARMs schedule rate adjustments more frequently. “We have an ARM product that adjusts every six months,” says Merrick of TCF Mortgage. On the West Coast, mortgages that adjust even more frequently-even monthly-are common. Borrowers opt for these when they believe market interest rates are headed downward, says Moloney.
“If you look at the last four years, ARMs tied to a cost-of-funds index have been going down every month,” Moloney notes.
On the other hand, some adjustables don’t adjust at all the first two or three or five years, but after that period they begin adjusting annually. The “three-one,” which begins adjusting after the first three years, is offered at an interest rate about one percentage point lower than the rate on 30-year fixed-rate loans, says Merrick. These loans are tailored for borrowers who don’t want to worry about rate adjustments for a while. Lenders qualify borrowers at the initial rate, rather than at the adjustment, which won’t occur for at least a couple of years down the road.
And some ARMs are “convertible,” which means that the lender will allow borrowers to later convert to the rate being offered on fixed-rate mortgages, plus a small margin, such as 0.25 percent, for the trouble of making the switch. An ARM without the conversion option is usually offered for about three percentage points below 30-year fixed rates, and a convertible ARM is offered for about 2.5 percent less, says Merrick.
Calculating confusion
While the variety of ARM options may make it easier to find a loan to meet your budget, servicing the loans is a nightmare for the lenders’ overworked staffers, says Moloney. And even though lenders try to adopt uniform mortgage contracts, so that the loans can later be sold off to investors, there are differences in ARMs and the way they are adjusted-the indexes and margins used, as well as rules on how to round to the nearest percentage rate.
Moloney’s firm is one of several non-profits nationwide that monitor whether borrowers’ ARMs are adjusted correctly. “We find that 48 percent of the cases we monitor have an error,” says Moloney. “And about one-third of the errors are overcharges.”
For borrowers who do decide to take up ARMs, Moloney observes that they should study their contract and check the rise in the index used for adjustments.
However, he notes that most borrowers simply aren’t that vigilant. “Reading through a loan document isn’t exactly pleasure reading. Most people close on a loan and never study the contract again.”
