4 reasons why variable rate mortgages are on the rise again
When the time comes to take out a mortgage on a property, there are many different types of loans. From government backed VA and FHA loans to conventional 15, 20, or 30 year fixed rate loans, there are many options to consider. One avenue that you may not have considered – and that you may have even been warned against – however, is an adjustable rate mortgage or an ARM loan.
Variable rate mortgages got a bad rap in the 2007 housing crash and put the lending practices of many banks under the microscope. During this time, lenders often used ARMs, which carry lower initial interest rates, to get borrower payments where they need to be to qualify for loans. The trap ? When the interest rate adjusted, borrowers would end up with a higher interest rate and, in many cases, a higher payment that they simply could not afford.
What exactly is an ARM?
A variable rate mortgage (ARM) is not a long-term, fixed rate mortgage. Instead, it offers borrowers a lower initial interest rate for a shorter fixed period – typically three, five, or seven years. While the principal and interest payment on the loan is always calculated over 30 years, the interest rate changes based on several factors after the three, five or seven year period has passed. These factors include:
Interest Rate Indices – ARMs are linked to an interest rate index such as the London Interbank Offered Rate, also known as Libor. Libor is one of the benchmark rate indices used by major banks to dictate what they will charge each other for short-term loans.
Margins – The loan margin is established upon initial loan approval and remains fixed in its entirety. The margin is a fixed percentage that is added to a loan index rate to get the fully indexed rate for an ARM. For example, if your index rate is 3% and your margin is 3%, your fully indexed interest rate would be 6%. Margins can sometimes be negotiated with the mortgage lender.
Interest Limits – ARMs typically have a cap that sets a maximum interest rate and a periodic cap limiting how much the interest rate can change during a single adjustment period.
Why more and more people are choosing MRAs
As the general public becomes more aware of ARM loans and their potential benefits and pitfalls, more borrowers are opting for these types of mortgages when it makes sense. Let’s take a look at four of the reasons why more and more borrowers are opting for MRAs today.
1. Lower interest rates = lower monthly payments
When interest rates are already low, ARMs are less popular among borrowers. But because the interest rates on ARM loans are always lower than those on conventional fixed rate loans – typically around 0.5% – they are especially attractive when conventional interest rates are high. During these times, borrowers are often willing to risk a higher future rate in exchange for lower payments now.
2. Short term loans
Some homebuyers choose ARMs because they know they won’t hold the loan long enough for the introductory rate to expire. Therefore, they know they can avoid the interest rate adjustment. For this reason, ARMs can be a good option for those buying investment properties or properties for renovation that they intend to hold for only a few years. The most popular ARM loans have fixed rate terms of five or seven years, which gives most investors enough time to get in and out of the property and make the lowest possible payments in the meantime.
See today’s mortgage interest rates
A word of warning here: It is important to make sure that you are aware of the prepayment penalties associated with the loan. For example, some loans carry a penalty of 2% or 3% if they are prepaid. Refinancing a loan or selling the property both results in the repayment of the original loan and this penalty may be imposed in these cases if the prepayment period has not yet expired. This can end up costing an unintentional owner a significant chunk of change. Therefore, be sure to ask your lender for the details of the prepayment penalty if you plan to refinance your lower payment after the initial low interest period expires or sell the property quickly.
3. Reduced risk of fraud
While MRAs are less attractive to some borrowers, they are also less attractive to identity thieves and potential criminals, recent data shows. First American, which provides mortgage and title services, said earlier this year that there is now less risk of fraud associated with variable rate mortgage applications than with conventional loans.
“Historically, ARMs have been more prone to defaults, fraud and misrepresentation than traditional 30-year fixed rate mortgages,” said Mark Fleming, chief economist at First American. “Interestingly, that has changed recently. ARM, based on our index of vices, fraud and false declarations, are slightly less risky.
4. Lower credit scores
Borrowers with credit scores who fall below 680 are less likely to qualify for conventional loans and will therefore end up paying higher interest rates. Higher interest means higher monthly payments. Borrowers and their lenders often get around this problem with an ARM loan. The associated lower interest rate can make a big difference in a borrower’s ability to qualify for a mortgage and make the monthly loan payment.
Should we consider an ARM?
If you’re interested in an adjustable rate mortgage for these or other reasons, it’s important to weigh the pros and cons with your mortgage lender to ultimately determine if an ARM is right for you. If you think your credit score may be preventing you from qualifying for a low interest conventional loan, it’s a good idea to do a free check on your. credit rating before you apply for a mortgage. It can save you money in the long run.