All ARM’s are not created equal

May 5, 2008

Understanding mortgage choices for Charleston South Carolina real estate My annual termite inspection was this morning to maintain the termite bond on my home. (By the way, if you live in the Charleston area, you should maintain a termite bond because it isn’t a question of if but when.)

But the reason for this post was that the inspector (after learning that I am a real estate agent) said that he was considering buying a home but not with an adjustable rate mortgage (ARM) because he felt they were bad.

I’m not surprised because with the media focus on all the problems in the mortgage market today, people have good reasons to not understand that all ARM’s are not created equal.

If you understand that an ARM is fixed depending on the term you select and will not reset to a higher rate for either 3, 5 7 or 10 years and that is how long you plan to live in your home, it might be a good decision to choose an ARM. If you understand that there are limits to how much an ARM can reset after that period and what the maximum rate can be, it might be a good decision. But the most important thing is whether there is a wide enough rate spread between a 30 year fixed rate and an ARM.

Now of course, many people didn’t understand what an ARM really meant while others chose to ignore what they were told because they figured (incorrectly) they could refinance later when their home increased significantly in value (and possibly take some equity out at the same time).

But let’s talk briefly about the really destructive ARM, the Option ARM. With this product, you are paying an artificially low 1% rate the first month and there is no limit on how much the rate can reset the second month. Your payment doesn’t change for the first full year but you owe the difference. But the most evil thing about the Option ARM is that because you have an artificially low payment and it is your option to pay more than the minimum, if and when you don’t (and most people don’t), you owe more on your house after a year than when you bought it (this is called a negative amortization loan). And when the payment increases, you may not be able to afford your home.

The Option ARM is one of the many reasons that homeowners are finding themselves in financial trouble today and why there are so many foreclosures. But all ARM’s are not created equal and an ARM is not necessarily a bad mortgage choice.

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