Saturday, September 16, 2006

Avoiding an Expensive Mortgage Mistake

If you are considering a refinancing or taking out a mortgage to buy a house, understand the terms, pros and cons of your specific mortgage type. Not doing so can be an expensive mistake.

I am the conservative type when it comes to debt. I have owned two houses. Both of them were purchased with fixed rate mortgages. For my first house, I put down 20% for a 12%, 30 year mortgage which had yearly payment increase to payoff in 15 years. For our second house, we put down 40% on a 5.375%, 30 year mortgage.

I have never seriously considered an adjustable rate mortgage (ARM) or an Option ARM. I didn’t want to have the risk of interest rates increasing. Twenty years ago, using an ARM mortgage proved to be the right choice. A colleague of mine purchased a house in the 1980’s with an ARM and has had an equal or lower interest rate with each adjustment.

Recently, ARMs and Option ARMs have proven to be a bad choice, and in some cases, a punishing choice. As Business Week points out, many homeowners will receive a very unpleasant adjustment to their mortgage this year, one they cannot afford and, therefore, may lose their homes. Some of these same people created their own nightmare by trading a conservative fixed rate loan for the risky ARMs. They did not understand the risks.

Bottom line, if you can’t afford a house with a standard fixed rate mortgage, then it is likely you can’t afford the house at this time. Rather than take on a risky mortgage, work on saving more to put down a larger down payment or buy a smaller house.

This is not financial or investment advice. Please consult a professional advisor.

Copyright © 2006 Achievement Catalyst, LLC


GolbGuru said...

Is there some kind of a interest rate cap for ARMs ? or they are going to keep rising till people cant afford them anymore? With the falling gasoline prices, there are chances that the economy may heat up and fuel interest rate hikes.

Super Saver said...

Good question. The answer is yes there are limitations to interest increase and decrease (in a declining rate environments) amounts. There are usually two caps, one for each adjustment and one for the life of the loan. The adjustment cap is the maximum change that can occur for the periodic changes – typically around 1-2% but can be as high as 5%. For example, if a loan has a 2% adjustment cap and interest rates rise 4%, the loan interest is only increased 2% for the next period. The life of the loan cap is the maximum change from the initial rate that can happen over the full term – typically around 5%, I think. So if your initial rate is 5.5%, the minimum and maximum rates anytime during the life of the loan are 0.5% (we wish:-) and 10.5% (arrgh) respectively.

There are also limitations the frequency of adjustment.

Fixed Rate Period. ARMs typically have a period when the interest interest is fixed. Typically, it is 1, 3, 5 or 7 years. The longer the fixed period, the higher the intial interested rate.

Adjustment Period. After the fixed rate period, ARMs will adjust once or twice a year. Usually, 1 indicates a yearly adjustment, and a 6 indicates an adjustment every 6 months.

For example, an ARM with a 3 year fixed period and adjustment every year after 3 is a 3/1 ARM.

The issue is that many people use an ARM because it has a lower payment than a fixed rate mortgage, and they could not afford or qualify for the fixed rate mortgage. With interest rates rising over the last 3 years, some of these people are experiencing the same affordability difficulty again, even with caps.

GolbGuru said...

You should probably make a post out of this. I am sure many people will be interested in this information. Thanks much.

Super Saver said...

Thanks for the suggestion. I appreciate comments on what content may be of interest to readers. I have another real estate post that also has additional information. I will consolidate both updates into one future real estate post.

Kelly said...

Thanks for the post. The information on ARM's and FRM's is very efficiently explained.