Non-Exploding ARM's

Setting the Record Straight on ARM's

It's easy to think that every adjustable rate mortgage ("ARM") burned the borrowers who took them out.

After all, aren't so-called "Option ARM's" supposed to be financial time bombs?

They are, but most ARM's don't function that way (at least, the ones most common outside of Southern California, Arizona, and Florida).

Option-ARM's

With an option ARM, the borrower effectively chooses to re-pay whatever they want --including virtually nothing -- for a prescribed period of time (usually 5 years).

Any shortfall is simply added to the balance of their mortgage.

So, an Option-ARM borrower who decided to make only tiny monthly payments could easily see their loan balance double, as all the accrued interest piled up on the (unpaid) principal.

As millions have now discovered, a mushrooming mortgage balance on a house that's rapidly losing value is a nasty combination.

Plain Vanilla ARM's

Fortunately, that's not how most ARM's work.

While the formula varies by lender, the plain-vanilla version typically features an initial teaser rate that's fixed for a prescribed period of time (often, 5 years). (FYI, big banks today are offering 5/1 ARM's at 3.625%, vs. fixed, 30-year rates just under 5%).

After that, the rate re-sets annually based on a predefined formula; popular ones include LIBOR ("London Interbank Offer Rate") or 10-year U.S. Treasury notes, plus anywhere from 2% to 4%.

Another feature of ARM's is a ceiling on how much the maximum upward bump can be over the life of the loan.

Sitting Pretty

So, where does that leave people who took out ARM's in 2005, that are re-setting in today's environment of infinitesimal interest rates?

In many cases, with rates that are re-setting lower.

Thanks, Ben! (as in Fed Chairman Ben Bernanke, whose appointment to a second term was just confirmed by the Senate yesterday).

P.S.: Another reason why ARM's have bit fewer people than you might expect: they sold their home before their interest rates re-set.

Given that the average homeowner moves every 7 years, statistically, a high percentage would retire their ARM loan before the 5 year re-set date ever arrived.

In fact, that's one of the strongest arguments for getting an ARM in the first place, i.e., why pay a premium for a 30-year mortgage when your time horizon is much shorter?