The Truth About Adjustable Rate Mortgages

By George L. Duarte, MBA, CMC

In this era of rising loan rates, and in this expensive state of California, consumers are more motivated than ever to keep their mortgage loan payments as low as possible. Accordingly, there is an adjustable rate loan program that has become very popular with lenders and mortgage brokers to sell to consumers, and it goes by several different names. Terms such as “Pay Option ARM”, “Pick a Pay”, “Cash Flow ARM”, “Monthly ARM”, “Low Fixed Payment ARM” and many others are bandied about, but all refer to the same loan- an adjustable rate mortgage where the interest rate adjusts monthly, and the minimum payments are fixed for one year at a time.

This is the most complicated residential mortgage loan program that is available to the general public today, and there are many misconceptions about this loan program, both by consumers and lenders who offer it. It is important to understand that this is not a bad loan. Contrary to the opinion of many people, there are actually no bad loan programs, all currently existing loan programs have their place in the market. The loans aren’t bad, the people who originate the loans improperly are. Now the reality- whether a loan program is bad or not is relative to the particular circumstances of the borrowers who are looking for a loan. What is bad about loan programs for consumers are not the loan features, but when loan programs are sold to people WITHOUT THE FULL DISCLOSURE OF THE LOAN FEATURES, AND WHAT THEY MEAN TO THE CONSUMER.

Herein lies the main problem of the “monthly adjustable rate loan”. It has several very dramatic features to it that are rarely, if ever, properly disclosed to the consumer that they exist at all, and how they affect the loan performance and the consumer’s position. This is very unfortunate, because these loan features can be very beneficial to the consumer, if the consumer knows they exist, and how to manage them to their maximum benefit. But a loan with these features in the hands of an uninformed consumer can be disastrous. Here are scary terms- “negative amortization”, “prepayment penalty”  and “yield spread premium” that are integral features of this loan. If a consumer doesn’t know what these things are and what they mean, this loan will hurt them, and possibly a lot. Unfortunately, these terms are obscured by incompetent and even deceitful loan originators, who don’t want consumers to know how they really work, because it will foul up their sales pitch.  How would you like a loan that is fixed for 30 years at 1.00%? An awesome deal right, who wouldn’t? That is how this loan is sold very frequently, and while the exact terminology is correct, it is in fact completely misleading and fraudulent. You see, the term of the loan is 30 years, meaning the lender wants all their money back in 30 years. The minimum payment of the loan is fixed, but only for one year at a time, and based upon the start rate of 1.00%. The actual fully amortized payment due each month will be in the 6.5%- 7.5% range. If a consumer pays only the minimum payment due, the lender is happy, but they don’t pay all the interest and none of the principal they actually owe. So then what happens? The amount of interest owed but not paid is ADDED to the loan balance, and the loan balance is higher on the next statement, so the consumer pays (and owes) interest on an increasing balance. This is known as “negative amortization”, but that is considered a terrifying term for consumers, so lenders call it a more benign term- “deferred interest”. Sounds terrible, doesn’t it? Well, if a consumer doesn’t know how this is working they can wake up one day in two or three years and see their loan balance $30,000 or $40,000 higher than when they started. They usually find this out when they go to refinance, or sell the house to buy another. Obviously, this discovery will have a very bad effect on the plans to refinance or purchase a new home.

Many consumer advocates feel strongly that this loan feature should be outlawed, because of the effects stated above. How can a loan with this feature be any good for the consumer at all? Here’s how the problem of negative amortization is overcome- in California, on average, property values have increased about 9.00% per year since 1970, per CAR statistics. Even if you take a very conservative approach and half that figure to 4.5% per year, that means a $500,000 home this year will be worth $522,500 a year from now. If this person has a $400,000 loan and makes the minimum payment, their loan balance will increase approximately $12,500 in the one year. But the home value has appreciated $10,000 more than the loan balance has gone up, and the consumer has that $12,500 in his pocket that he didn’t pay in mortgage payments, so the property appreciation has in fact subsidized the consumer’s mortgage loan payment! The consumer has that $12,500 that he didn’t pay on his loan payments available for other things- consumer debt reduction, college savings, or development of a diversified portfolio of other investments- financial planners take note!

So you see that this loan feature that can be so deadly to the uninformed consumer can be a powerful equity and cash flow management tool to the informed and sophisticated consumer. It is also a great loan for people who are investors in rental property, people who are self employed, have seasonal income, or hard to verify income.

Even with these and other benefits, this loan is just not for everyone, and there are many people that it would not be right for. At Horizon Financial Associates here in Fremont since 1988, we counsel with our clients, provide custom tailored loan solutions and loan program choices. We do not cram people into a “one size fits all” cookie cutter program, and fully examine and explain loan programs, features, benefits and how they affect the client. We are not “rate and no closing costs loan hacks”, we provide a comprehensive consultative service for sophisticated intangible financial products to the maximum benefit of our clients. I invite you to experience the Horizon Financial Associates difference, check our website at www.horizonfinance.com, or call us at 800-956-MONEY(6663).