A significantly larger portion of mortgages over the past several years have been ARM�s than in previous periods, and this is largely due to the dramatically lower interest rates and availability of financing for real estate purchases.
The ARM is an attractive alternative to those individuals with income that is just short of what would be comfortable when considering a home purchase, or for those individuals looking to take advantage of current interest rates for real estate investment purposes. For those borrowers who are inexperienced, or are simply not appropriately informed as to the features of the ARM they�re getting, a dangerous situation may lie just beyond the horizon.
How an ARM Works
Let�s begin by briefly explaining how an ARM works, and then relay that to how these contracts may present borrowers with a threatening dilemma that could cost them their home. To begin, an Adjustable Rate Mortgage is intended to allow a borrower to pay a lower interest rate for a short period of time, typically between one and five years, and then pay a rate that will change along with the current mortgage interest rates at that time.
The initial payment amount depends on the duration of the fixed period at the beginning of the contract. Subsequent payment amounts will change based on the mortgage contract�s specified provisions, which usually allow for the lender to increase the interest rate up to a maximum percentage (typically around 2%) at any given time.
Provisions Determine How Often and How Much The Interest Rate Can Increase
There are additional provisions which specify how often an increase can occur, and how many can occur within the life of the loan. ARM�s are still based on a 30-year repayment period, and the monthly payment amounts are designed to work with the worst case scenario. This means that the lender has calculated what payment amount will be necessary at each stage of the contract to get the loan fully paid off within the allocated time, therefore a minimum payment has already been established. However, this does not mean that the borrower can determine what the new payments will be when he reaches a new adjustable period, and this is because the lender will adjust his payments to take advantage of whatever increases are permitted.
Difficult to Project What Future Payments May Be
Understanding how the ARM works is not difficult, but projecting how it will effect a borrower�s particular contract is almost impossible. Because there is no way to determine exactly what the borrower�s new payments will be at the beginning of each adjustable period, the borrower must be prepared for the worst case, or the highest payment permitted by the contract. Calculating what the highest payment permitted could be is also not difficult, and can be determined with some minor mathematical effort.
The Borrower Must Expect and Plan For the Increased Payment
However, the reality is that most borrowers become accustomed to their initial payment and forget that their monthly bill will be subject to new variables, and they are caught off guard when they receive a letter from the lender explaining their new payment. Since the majority of Americans have a dangerously small cash reserve account (the average being around $3,000), there is little time for them to prepare for the new payment once they receive notification of an increase. Additionally, the provisions of each ARM will be different with respect to how long each new payment will be static.
Increased Likelihood of Foreclosure
For the borrower with a contract stipulating that the lender can adjust interest rates and payment amounts as often as they�d like, this presents a significant danger because the borrower will be unable to predict the new monthly amount due. Because the majority of Americans spend their money first and save little, if anything, there exists an extremely high likelihood that foreclosure will become a foreseeable outcome for those individuals with poor credit. A borrower with an ARM and a poor credit history is in the worst situation imaginable because there is little chance of him refinancing his loan to bring about a positive change. This is even more so for the borrower whose income is barely high enough to cover the initial teaser rate of the contract.
Reasons People Get ARMS
You might ask yourself how or why a borrower could intentionally agree to an ARM when they know full well that they will most likely not be able to afford the increased payments later; this question is legitimate, yet the situation is all too common. Many borrowers will agree to a contract they know they cannot afford simply because they are desperate to get a house. Others will take an ARM because they cannot afford the payments on a traditional fixed contract, and their original intentions (however legitimate they may actually be), are to attempt to refinance the ARM before their fixed period expires, or find other means of income during that time. The problem with this thought process is that most Americans are also procrastinators and have a difficult time, psychologically, focusing on the reality of their poor financial security. A number of Financial Sociologists have agreed that Americans tend to ignore the ever-pressing dangers of their consistent over-spending and under-saving. Although most borrowers who fall into this category have good intentions at the outset of their mortgage, the truth is that most actually do very little to prepare for their payment increase. In fact, many borrowers end up in a worse financial situation during the few years of fixed payments because they focus too much on superficial status symbols that leave them with an even further negative net worth. Their priorities are not consistent with an intent to improve their status, therefore the actual planning that goes into preparing for their future financial situation is non-existent.
30 Year Fixed Loan is a Better Alternative for the Average Borrower
This is why the lender�s notice of a payment increase comes as such a shock, and why the borrowers are usually unable to comfortably pay the higher amount. Considering all of these factors, it is advisable that your average American mortgage seeker avoid an Adjustable Rate Mortgage, despite the attractive initial payment and interest rate. The average borrower will be much more secure with a traditional 30-year fixed rate mortgage.