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Safe ARM?

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Posted On: 12/21/2016

Question: We know that fixed mortgage rates are low, but adjustable-rate financing is even lower. Why shouldn’t we finance with an ARM?

Answer: Despite attractive initial interest rates, ARMs represent fewer than 5 percent of all mortgage originations according to Ellie Mae. In mid-October, Freddie Mac reported 30-year, fixed-rate prime financing was priced at 3.47 percent versus 2.82 percent for a 5/1 ARM, a form of financing which has a fixed rate for the first five years of the loan term and then adjusts up or down annually.

In practical terms the difference is this: If you borrow $175,000 at 3.47 percent the monthly payment for principal and interest is $782.90. The same loan at 2.82 percent would have a monthly cost of $720.93 for the first five years of the loan term.

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The difference between the two loans is $61.97 a month, $744 annually and $3,720 over five years. Not only that, but because of the lower monthly cost a borrower can finance a larger loan with an ARM.

Given this reality how come borrowers are not lining up for ARM financing?

The answer concerns the issue of risk.

One of the great lessons of the mortgage meltdown is that quirky loans with changing costs are to be avoided.

Today’s ARMs, however, are far less risky than many past adjustable-rate products. Here’s why:

First, under Dodd-Frank pre-payment penalties are limited for “qualified mortgages” (QMs) such as FHA, VA and conforming loans. In practice, there are no prepayment penalties for such mortgages.

Second, under Dodd-Frank pre-payment penalties are banned for “non-qualified mortgages” (non-QMs).

Third, under Dodd-Frank “qualified mortgages” cannot have negative amortization or balloon payments.

Fourth, under Dodd-Frank borrowers must be qualified on the basis of the highest ARM payment they can expect to make during the first five years of the mortgage term and not the start rate.

The result of the Dodd-Frank rules is that ARMs today are far less risky than the toxic products allowed before the mortgage meltdown.

That said many people still want financial stability. While it is true that ARM rates can decline after start periods end, it is equally true that they can increase – and maybe increase at a time when borrowers have less income or have lost a job. The result is that while today’s ARMs are a very much better financial product when compared with adjustable mortgages marketed in the past, for reasons of risk they are simply not what most borrowers want.

Peter G. Miller is author of "The Common-Sense Mortgage," (Kindle 2016). Have a question? Please write to peter@ctwfeatures.com.

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