Adjustable-rate mortgages were created to make home-buying more affordable and became quite popular when the fixed-rate mortgages shot up in the early 1980s. After all, at the time, why pay 12 or 15 percent on your mortgage when you could get an adjustable-rate mortgage at half that or less? When a borrower accepts an ARM, he is accepting the risk that if rates go up, his payments will go up. In the meantime, he will enjoy lower payments than offered by fixed-rate mortgages.
Today's adjustable-rate mortgages come in a wide variety of options. The most popular ones offer an initial fixed period of 3, 5 or 7 years. After that "honeymoon" phase is over, the rate typically begins adjusting on a once-a-year basis. With today's fixed rates hovering under 4 percent, the initial fixed-rate period on today's ARMs may carry a rate fixed at 2.5 to 3 percent.
Gone are the days when an ARM offered an initial interest rate at 1 or 2 percent for the first month and then adjusted sharply upward after that. That was one of the types of ARMs that was identified as a reason for the sharp increase in defaults and foreclosures in the past five or six years.
Lenders use the debt-to-income ratio to income qualify a potential borrower. We take the new monthly PITI (Principal, Interest, Taxes, Insurance) plus any other long term debts (car payments, student loans, credit card payments, spousal support, etc.) and divide that by gross monthly income. Current guidelines allow DTI ratios up to 45-50 percent. Of course, the interest rate that is used to calculate the payment will greatly influence that DTI ratio.
While the mortgage payments for the fixed-rate period of an ARM will likely be lower than the payments on a fixed-rate mortgage, qualifying is not any easier for a borrower accepting an ARM because it is common for lending guidelines to require a borrower to qualify for the mortgage based on the initial interest rate plus 2 percent. In fact, qualifying for an ARM can be more rigorous than qualifying for a 30-year fixed-rate mortgage.
For the most part, those borrowers still with ARMs have experienced downward pressure on their rates over the past 4 or more years; however, that is about to change. Although the Fed has vowed to keep downward pressure on rates through 2014, don't count on it. As the economy picks up steam, there will be upward pressure on rates. Those who have ARMs will see rates rise and those who are seeking mortgages will find that 30-year fixed-rates in the mid 3 percent range are a thing of the past. One of the most volatile of all ARMs is the Home Equity Line of Credit (HELOC) as most are tied to the Prime Rate, which has historically increased (or decreased) at 1 percent or more per year. With the Prime Rate sitting at 3.25 percent, its lowest rate ever, since December 2008, there is a lot of upward potential. Those with HELOCs tied to such a volatile index are well advised to consider assessing their present and future needs and to make a change if advisable.
Local mortgage consultant Peter Boutell has been writing a weekly column for the Sentinel since 1995. Send questions to 'Lending a Hand,' 1535 Seabright Ave., Santa Cruz, CA 95062, fax them to 425-1044 or email them to firstname.lastname@example.org. Archived columns are available at www.peterboutell.com.