Strategic ARMs: adjustable rate loans

The housing market in Northern Colorado is a high-stakes game.
When people buy homes – so the wisdom goes – it is good for 1,000 industries. It follows, then, that if home building in Northern Colorado were to collapse tomorrow, the economic effects would be devastating.
Consequently, as one means for buoying up the home building and sales market sinks, another must rise to keep the market afloat.
The habits of building, buying, selling and lending that emerged during the expanding 1990s (then enabled by historic lows in interests rates to remain strong) now ride on a host of new mortgage products designed to keep the market – and all the 1,000 industries – robust.
“The refi (refinancing) boom is gone because rates have drifted up,´ said Merle Green, owner of the Green Financial Center in Greeley. “You might say that ARMs (adjustable rate mortgages) are the refi boom of today. They are designed to keep the velocity going in the real estate market and to keep all those people in it employed.”
When at the turn of the 21st century interest rates and the economy began their downward trend, those in the residential mortgage market were quick to point out that the time was ripe to leverage some home equity (a gift of rising home values) to buy investment property.
New products on the market have kept that leveraging option alive, even as rates for conventional loans have crept up.
The mortgage product that has most recently kept the market up to speed is the 100 percent, interest-only ARM loan.
On the seller’s side, this kind of loan increases the pool of qualified buyers. For those buyers, the loan’s appeal generally depends on one condition and one hope. The condition is that the potential buyer typically does not have money for a down payment, and the hope is that homes in Northern Colorado will continue to appreciate at roughly 6 percent per year. Interest-only payments accrue no equity.
“This kind of loan is nice because the buyer only has to qualify on the payment of the interest,´ said Konnie Reynolds, executive vice president of Loan Perfect. “Some people have good jobs, but have not been able to save for a down payment, or they may be self-employed.”
Reynolds explained the mechanics of a 5/1 ARM – where the rate is fixed for the first five years and then adjusts yearly after that. The 5/1 ARM, if set up as a no down payment, interest-only loan would work something like this:
First, start with the cost of the home at $187,500. A fully amortized payment on a $150,000 loan at 4.5 percent would be $760 per month, while the interest-only payment would be $554.79. The buyer saves around $200 per month.
But what of that pesky $37,500 that would have been the 20 percent down payment?
“The buyer will finance the $37,500 as a second mortgage at 7.25 percent and pay $226.04 per month,” she said. “The two payments combined come out about the same as the fully amortized payment, but the buyer has not had to come up with a down payment or qualify on the higher amount.”
Reynolds noted the difference in the first and second loan rates is that the first is a mortgage rate, while the second is a consumer bank loan rate.
What a buyer gives up with the interest-only ARM product is the automatic accumulation of equity and the assurance that the rate will remain the same for the duration of the loan. However, proponents of these loans argue that houses continue to appreciate and everything paid out in interest is tax deductible. The same amount of money spent on rent is money out the window.
“People are fearful that the rate will go up,´ said Stephanie Kelly, loan officer for Mountain West Mortgage in Loveland. “But as you weigh your risk, think about the tax benefits of home ownership and all the new products that will be on the market when it is time to refinance.”
Those strapped for a down payment are not the only buyers who find the interest-only ARM loan attractive.
“Because rents have softened in the region, we are seeing people doing (interest-only) loans to increase cash flow,´ said Reynolds.
Green agreed and pointed out that using interest-only loans to buy investment properties makes very good sense.
“It is possible to buy a duplex, for example, that is rented and bringing in $1,400 per month for a payment of around $700 per month with an (interest-only) loan,” he said. “Immediately the buyer adds $700 a month to cash flow.”
If the calculations surrounding ARMs and interest-only loans sound complicated, it is because they are complicated. The creative mixing and matching of time, interest, indexes and margins can be so confusing that three years ago the Federal Reserve board and the Office of Thrift Supervision prepared a pamphlet “designed to help consumers understand an important and complex mortgage option available to homebuyers.”
The pamphlet touches on some of the reasons that Corky Pappas, owner of The Mortgage Connection, views some versions of ARMs and interest-only loans with a healthy skepticism.
“There are 40 to 50 kinds of loans out there, and it is the complete responsibility of the borrower to understand the terms of the loan,” she said. “You have to look at what index will be used to determine the adjustment, and you have to be aware that if a payment cap is too low to cover the interest dues, the result will be negative amortization.”
According to the Fed’s pamphlet, “Negative amortization occurs when the monthly payments do not cover all the interest cost. The interest cost that is not covered is added to the unpaid principal balance.”
In other words, the loan amount begins to grow.
While the trend toward zero down payment, interest only loans makes Pappas uneasy, she acknowledges that the hybrid interest-only ARM is a nice solution for responsible borrowers for whom cash flow is important.
“If you have the discipline to pay down the loan, then it’s OK,” she said. “I have been through a declining market. When appraisers begin writing for a declining market and when the price of oil and other expenses are going up, it might not be such a good idea to get too excited about an adjustable 3 percent rate.”