Adjustable-rate mortgages can lead to confusion

Friday, May 9, 2008 | 5:48 p.m. CDT; updated 2:18 p.m. CDT, Tuesday, July 22, 2008

COLUMBIA — Given the complexities of adjustable-rate mortgages, it should come as no surprise that this type of borrowing can give rise to confusion.

Joanna Kollmeyer, a certified financial counselor at Consumer Credit Counseling Service in Columbia, said she’s seen homeowners who weren’t aware of the particular terms of their adjustable-rate mortgage even though all of the details were spelled out in lending documents.

Adjustable-rate mortgages


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Prospective homeowners can choose from three types of ARMs: hybrid, interest-only and payment-option ARMs. Lenders and mortgage brokers say the hybrid ARM, which has a fixed-rate period and an adjustable-rate period, has been the most common throughout mid-Missouri. Hybrid ARMs have a rating of two numbers, according to the Federal Reserve Board: the first tells how long the fixed period of the interest rate lasts; the second tells how frequently the interest rate will adjust after the fixed period ends. For example, a 5/1 ARM will stay fixed for five years and adjust annually for the rest of the loan’s term. Lenders establish the rates of ARMs based on indexes such as the Cost of Funds Index and the London Interbank Offered Rate. According to the Federal Reserve Board, lenders can also add percentage points to the index rate, which is called the margin. An ARM’s total interest rate is the margin plus the index. ARMs have two types of interest-rate caps: periodic adjustment caps that limit how much an interest rate can adjust from one period to the next, according to the Federal Reserve Board, and lifetime caps on the total interest-rate increase over the life of the loan. Some ARMs include a prepayment penalty, meaning if the homeowner wants out of the loan before the fixed period ended, they would have to pay the penalty, sometimes 2 percent of the mortgage. “They’re kind of tied to that loan,” Chris Sanders of Allied Mortgage said.

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“Some people knew it was going to go up but they didn’t know it was going to be that high,” she said. “Others didn’t even know it was adjustable. They saw fixed and thought fixed.”

The merits of taking out an adjustable-rate mortgage, like other financial options, depend on the individual borrower.

“An ARM is not a bad product, but it’s situational,” Chris Sanders of Allied Mortgage said. “It has to make sense for the customer. You wouldn’t want to put everyone in an ARM.”

The interest rate on ARMs was nearly a full percentage point less during the fixed period of the loan than regular fixed-rate loans a few years ago, Sanders said, making them attractive.

“Back then, it made perfect sense to do a five-year ARM,” Sanders said.

These days, Sanders said, home buyers sign adjustable-rate mortgages as a way of buying time to fix their credit or build up equity. But some have struggled with the increase in interest payments that eventually kick in. After owning a home for two or three years, little equity has been built and the homeowner’s credit hasn’t changed much, either.

“It’s catching people in a firestorm. They can’t refinance. They can’t afford the payments,” Sanders said. “What do they do? They walk away.”

That can open the door for a bank or lender to initiate foreclosure proceedings.

Lately, the issuing of ARMs has calmed; the initial interest-rate of ARMs and the interest on fixed-rate mortgages differs by about a quarter of a percent.

“It’s a no-brainer to do a fixed-rate now,” Sanders said.

Shane Winter of Winter Financial Counseling in Columbia said brokers and lenders tried to attract homeowners to ARMs because they received their commission on the loan once the person signed, regardless of how long the person stayed in the home.

Sanders said many home buyers who took out adjustable-rate mortgages had solid credit and a good income, but were still put into an ARM.

“If I can summarize this,” Sanders said, “a lot of this all stemmed on greed.”

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