Potential Risks of Adjustable Rate Mortgages

Nearly 25% of all U.S. mortgages carry adjustable-rates (adjustable rate mortgages) and homeowners across the nation are starting to have trouble paying them back. Most of these loans went to borrowers with credit issues that were willing to accept higher interest rates in exchange for the opportunity to own a new home. For the 15th time since June 2004, the Federal Reserve has raised interest rates and more than likely, another increase is on it’s way. This is probably not the best news for borrowers who were sold an adjustable rate mortgage (ARM) that offered interest-only payment options or initial rates below 2% or allowed payments less than the interest owed. Borrowers are sure to face payment shock as their loans reset to a higher rate and their new house payment substantially increases.

Consumers that are considering an adjustable-rate mortgage need to fully understand what they are committing to. In two previous posts, Adjustable-Rate Mortgages: How They Work and Different Types of Adjustable-Rate Mortgages, I talked about the different aspects of ARMs and how they are structured. With nationwide foreclosures at an all time high, it’s very important that borrowers understand the potential pitfalls of taking out an ARM.

ARMs and Risk

There are some aspects of an ARM that borrowers should know about before choosing an adjustable-rate mortgage to buy a new house. Potential risks include: discounted interest rates, payment shock, negative amortization, prepay penalties and conversion fees.

Discounted Interest Rates

A lender may offer an initial rate lower than their fully indexed ARM rate.  Commonly referred to as teaser rates, start rates or discounted rates, this initial rate is usually combined with larger loan fees (points) and higher rates after the initial discounted rate period is over. The initial lower rate may only last until the first adjustment, so future payments need to be compared with those of a fully indexed adjustable-rate mortgage. With a deeply discounted initial rate, borrowers can set themselves up for payment shock, negative amortization, prepayment penalties and/or conversion fees.

Payment Shock

Payment shock is when there is an abrubt and substantial increase in a borrower’s loan payment. Every 5 or 10 years, the payment must be recast (recalculated) as a fully-amortizing payment. What this means is the payment raises to an amount that will pay off the loan - within the remaining term at the current interest rate, regardless of how large a payment increase is required. If the balance reaches the negative amortization maximum, the payment is then increased to the fully-amortizing level. Either a recast or negative amortization can result in serious payment shock for the borrower with difficulty paying back their home loan.

Negative Amortization

Negative amortization is when the amount owed on a loan increases even when the borrower makes timely payments. Negative amortization can occur whenever the monthly payments are not large enough to pay all the interest that’s due. The unpaid interest gets added to the principal resulting in the borrower owing more than what was originally borrowed. This can happen when a borrower is making only minimum payments on a payment-option mortgage or due to an ARM having a payment cap, limiting the amount of payment increases but not interest-rate increases. Ultimately, payments may not cover all the interest due on the loan. Unpaid interest then gets added to the principal and interest can be charged on that amount. The borrower can actually owe more on the loan after making numerous payments than at the onset of the loan.

Prepay Penalties and Conversion Fees

A lot of lenders will require the borrower to pay a prepay penalty if they want to refinance or pay an ARM off early (usually within 3 to 5 years). There are two differnet types of prepayment penalties that can occur: hard or soft. A hard penalty will require the borrower to pay an additional fee if the loan is paid off for any reason such as refinancing or selling the home. A soft penalty is paid if the loan is refinanced but not if the home is sold. A Lender can include a prepay penalty stipulation  if the borrower attempts to make a partial prepayment. Some ARMS may include a clause which allows the borrower to convert an ARM to a fixed-rate mortgage at designated times specific to the loan terms. Interest rates and/or up-front fees are generally higher for a convertible ARM.

Over seven million borrowers have taken out adjustable-rate mortgages over the past two years in order to buy new homes or refinance. Close to one million of these households will face the possibility of losing their homes to foreclosure within the next five years. Because people entered into ARMs without fully understanding the potential risks involved, these homeowners won’t be able to afford their mortgage payments and many will own homes that are worth less than they owe. If you are considering an ARM to purchase a new home, make sure you fully understand the potential risks involved with adjustable-rate mortgages. If you need more information on mortgages, visit the experts at New Homes Central Lending.

If you're new here, you may want to subscribe to our RSS feed.

You may also Subscribe to New Homes Real Estate Listings For Sale by Email Thanks for visiting!