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February 18, 2003
"I
plan to refinance my 7.25% loan into a 4% adjustable rate mortgage (ARM) that is
interest-only for 10 years. I don�t plan to hold this mortgage for more than 8
years. Unless I�m missing something, the decision seems like a
no-brainer."
You are missing something. The fact
that this ARM is interest-only for 10 years does not mean that the 4% rate holds
for 10 years. Probably it holds for only 6 months. Then, it can spike, or maybe
not, depending on what happens to market interest rates during the period, and
on other features of this loan that you don�t know about. This risk makes your
decision anything but a "no-brainer".
Your letter is one of many I have received
recently that ask about 10-year interest-only ARMs. It took me awhile to realize
what was going on. Some smart operators are taking advantage of the recent
popularity of interest-only loans to confuse borrowers into believing that the
tooth fairy has arrived. Only the tooth fairy is offering mortgages at 4% for 10
years.
These smart alecks don�t lie, but they
allow prospective borrowers to lie to themselves. Borrowers are left to assume
that the interest-only period is the same as the initial rate period. It is not.
The interest-only period is the period during which you are allowed to pay
interest only. The initial rate period is the period for which the quoted
interest rate holds.
To illustrate the difference, assume the
initial rate period is 6 months and the interest only period 10 years. On a
$100,000 loan at 4%, the interest-only payment is $333. If the rate after 6
months goes to 6%, the interest-only payment would jump to $500. It is higher
because the interest rate is higher, but it remains interest-only.
How fast and how far a rate increase might go
depends partly on what happens in the market. There is no way to know that. But
it also depends on the contractual features of this ARM, which you can know but
haven�t yet bothered to find out.
To find out at least how bad it could be �
the "worst case" � you need to know the following:
* How long the initial rate holds --
assume 6 months.
* How often the rate adjusts after the
initial rate period ends -- assume every 3 months.
* The maximum rate change -- assume 2%
on the first adjustment, 1% on subsequent adjustments.
* The highest rate allowed by the
contract -- assume 10%.
Using the assumptions I made above, under a
worst case the rate would rise from 4% to 10% in 18 months. On a $100,000 loan,
the initial payment of $333.34 would jump to $500 in month 7, to $583.34 in
month 10, to $666.67 in month 13, to $750 in month 16, and to $833.34 in month
19.
This example points up a hazard in an
interest-only ARM that loan officers are not likely to raise. The payment
increase resulting from an interest rate increase is significantly larger than
on an ARM that requires a fully-amortizing payment. A fully amortizing payment
includes principal and will pay off the balance at term. The payment on a
fully-amortizing ARM would begin at $477.42 and rise to $868.85 in month 19.
This is an 82% increase, compared to a 150% increase in the interest-only
payment.
This does not mean that the ARM under
discussion is a bad instrument that should be avoided. The point is that ARMs
should be selected with eyes wide open to their risk. It is the difference
between selecting an ARM and being sold an ARM.
Unfortunately, loan providers seldom
volunteer the information needed to assess the risk � you have to ask for it.
There is a checklist on my web site you can use for this purpose � see Information Needed to Evaluate an ARM. If the loan officer can�t
or won�t fill it in, run.
Copyright Jack Guttentag 2003
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