Combustible Adjustables: The Troubling Return of the ARM

Published

April 8, 2014

Mitchell D. Weiss is an experienced financial services industry executive and entrepreneur. He is an Executive in Residence at the University of Hartford and co-founder of the university’s Center for Personal Financial Responsibility. His books include Life Happens: A Practical Course on Personal Finance from College to Career and Business Happens: A Practical Guide to Entrepreneurial Finance for Small Businesses and Professional Practices—both of which are now undergraduate courses that Mitch teaches at the university and elsewhere.

It was only a matter of time.

Adjustable rate mortgages—the apocalyptical financial product of the recent economic collapse—are coming back in a big way. Of course, the banks insist that this time it’ll be different. At the moment, they’re targeting only high-net worth borrowers. According to a study that was developed for the Wall Street Journal, during the fourth quarter of 2013, roughly one-third of mortgages that ranged between $400,000 and $1 million, and nearly two-thirds of those over $1 million, were adjustable-rate mortgages.

But U.S. banks are under earnings pressure these days. Profit margins are shrinking, in part because demand for loans—mortgages in particular—has fallen off as interest rates have begun to rise and the economic recovery remains uncertain. Consequently, it’s reasonable to anticipate that lenders will once again rationalize their way to broadening the scope of their marketing efforts by relaxing credit underwriting standards. It also helps that ARMs end up shifting to borrowers the interest rate risk the lenders would otherwise have to take with fixed-rate loans.

When interest rates are stable and low—as they’ve been these past few years—conventional loans rule. But when the economy starts to crank and rates begin to move, which is beginning to happen now, adjustable loans can become awfully tempting for both borrowers and lenders. The hook is a low monthly payment to start—often, meaningfully lower than for a fixed-rate loan. Later on, of course, you’re playing with fire.

The issue is how much heat can you stand? Start by asking yourself these questions:

How much room do I have in my budget for a bigger monthly payment in the event that interest rates move up?
What if credit becomes tighter or if interest rates move up so much that I can’t refinance my way out of the loan?
What if I can’t sell my house for a price that’s high enough to pay off the debt I have against it?

It’s always better to plan for the worst rather than to be caught off guard by it. So let’s take a look at some numbers.

Suppose you were in the market for a 30-year, $200,000 mortgage. Let’s also suppose that you have several options including two that look like these:

A 4.5% fixed-rate mortgage. Your interest rate will stay at 4.5% (a $1,013.37 monthly payment on the $200,000 borrowed) for however long you decide to keep that mortgage.

A 3/1 adjustable-rate mortgage with a 2/2/6 CAP. Your interest rate will start at 3% (a $843.21 monthly payment on the $200,000) during a three-year introductory period. Afterward, the rate can adjust by up to 2 percentage points each year with a lifetime adjustment cap of 6 percentage points. That means if interest rates were to go crazy, your initial 3% rate could go to 5% after the first adjustment, 7% after the second adjustment and top out at 9% after the third.

That’s a whole lot of interest rates. I’ll put them into a table (courtesy of Bankrate.com’s ARM calculator) so that you can see what could happen to your monthly payments:

While the 3% ARM starts at a $170 advantage to the conventional loan, that benefit can turn into a $507 disadvantage as the monthly payments have the potential to almost double over time. That’s more than $6,000 of extra interest each year, once the 9% cap is reached!

Although most prefer conventional loans to ARMs—because budgeted loan payments aren’t something many consumers like to see change—there are those who don’t mind playing with financial fire for other reasons (they expect to sell the house before the first adjustment period comes to pass, for instance). If you’re one of them, consider one last bit of advice: Don’t be greedy! Interest rates are still unusually low. Is the $100 or $200 payment advantage I described above really worth the downside risk? When rates are at rock bottom, it’s all downside risk.

For more information, the Federal Reserve Board has developed a comprehensive guide.

This story is an Op/Ed contribution to Credit.com and does not necessarily represent the views of the company or its affiliates.