Adjustable rate mortgages can baffle their owners

Homeowners often don’t understand how they work

The business of mortgages is a complicated one, and few people ever have to deal with it more than a few times in their lives. When most people shop for a mortgage, they talk to a lender, discuss how much they earn, how much they owe and how much they would like to purchase. The lender makes recommendations regarding what type of loan would work best, and that is that. The 30 year, fixed rate mortgage has long been the most popular type, but if the lender suggests an adjustable rate mortgage, or ARM, the buyers usually go along with that.

This type of thinking comes with problems, as we shall soon see.

A recent study by the Federal Reserve Board demonstrates that many, if not most, people who have an adjustable rate mortgage do not understand how they work. Worse, they have no idea how much the way that ARMs work can affect their monthly payments. In this age of rising interest rates, this can be a huge problem.

Adjustable rate mortgages come in a number of different forms. Most offered these days have a fixed rate for some period of time. After that time period is over, the rate can adjust according to market forces. There are four things a buyer needs to know when considering an ARM:

• How often the rate can adjust. Every six months? Once a year? More often? Less often?
• How much the rate can change each time it adjusts. A quarter point? Half point? More?
• The cap on the interest rate. Most such mortgages have a ceiling or maximum rate that the loan can reach during its lifetime.
• The index used to calculate the adjustments. 

About 30-40% of people surveyed did not know the answer to one or more of the items in the list above. If you are going to take out a mortgage that can adjust over time, it is essential that you understand how often your payments can change and by how much they can increase. Otherwise, you could have sticker shock when the increase comes. This is a particular problem for those buyers who took out an Option ARM, a dangerous type of loan where the rates are set at an artificially low rate to start and where the buyer gets to decide each month how much he or she will pay. If the rates rise and the buyer has not been paying a sufficient amount, the lender can “recast” the loan and the buyer could easily see a 50% increase in the monthly payment.

This is not something you want to see if you bought a home on a tight budget.

The biggest problem with adjustable rate mortgages is that many buyers take them because they permit a lower payment than a fixed rate loan. For many buyers, this lower initial payment represents all they can afford to pay. If the rates go up, as they often do, these buyers may find themselves unable to afford the new, higher payments. This problem is making itself clear, as the number of foreclosures in the United States has dramatically increased during the last year. 

It would appear that more consumer education is needed on these types of loans.