From the June 2004 issue of Investment Advisor • Subscribe!

Debunking Myths About ARMs

While the number of home buyers using adjustable rate mortgages (ARMs) has increased to 35% from 14% a year ago, according to the latest figures from the Mortgage Bankers Association, there are still many people who don't understand ARMs. While it's true that these mortgages are not for everybody, they are an attractive mortgage-financing alternative for many.

In an effort to help you explain to your clients what ARMs are all about, the following outlines the 10 most common misperceptions or myths about ARMs, and their realities.

Myth #1: ARMs are not appropriate for the average borrower

REALITY: When you consider that the average life of a mortgage is currently six years, ARMs are often more appropriate for the average borrower than 30-year fixed-rate loans. In today's market, and in most markets over time, ARM loans carry a lower interest rate than 30-year fixed-rate loans. So if you are not planning on living in the same house for the next 10 years, paying the higher cost for a 30-year fixed-rate mortgage is like throwing money down the drain. For example, homeowners who know they will be refinancing or selling their home within five years would save thousands of dollars by electing a 5/1 ARM, in which the interest rate is fixed for the first five years and then adjusts annually, versus a 30-year fixed-rate loan.

The payment savings can be used to pay off the house faster, increase personal savings, or allow people to buy "more" home.

Myth #2: ARMs expose the borrower to payment shock

REALITY: Traditional ARMs adjust on a monthly, semi-annual, or annual basis. So in a rising-interest-rate environment, a borrower with an ARM can expect his or her mortgage rate and mortgage payment to rise. But when mortgage rates drop, so will the borrower's payment. Moreover, there are alternatives to short-term traditional ARMs, including a whole class of mortgage loans called hybrid ARMs, which have fixed interest rate periods from three to 10 years.

For borrowers who know they're going to be selling their home or refinancing within a set time frame, the hybrid ARM can be a wonderful alternative to a higher cost 30-year or 15-year fixed-rate mortgage.

Myth #3:ARMs are not a good choice in a rising-interest-rate environment

REALITY: ARM products are very different than they used to be. Today, many ARM products offer significant fixed-payment periods. As Federal Reserve Board Chairman Alan Greenspan famously remarked this spring, "Homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages (ARMs) rather than fixed-rate mortgages during the past decade."

Although ARM rates can increase, they also can decrease. If the borrower knows he or she will need to refinance the mortgage or sell the property some time in the future, an ARM is an economical alternative to a 30-year fixed- rate mortgage. For example, a 1.5% difference between a 30-year fixed-rate mortgage of $500,000 and a 5/1 ARM can save the borrower $37,500 in interest over a five-year period.

Myth #4:ARMs are more expensive than fixed-rate loans in the long run

REALITY: Generally, it is not true that ARMs are more expensive. The longer the term of the borrowing, the higher the interest rate. An ARM could be more expensive if you had a one-month, six-month, or one-year repricing ARM and interest rates did nothing but climb. However, interest rates move up and down, and as they do, a borrower's loan rate moves in the same direction. When you consider that the average life of a mortgage loan in the United States is only six years, it may not make sense for the average borrower to elect a 30-year fixed-rate loan.

Myth #5:ARMs are for borrowers with too little income to qualify for fixed-rate mortgages

REALITY: Although ARMs originally became popular during the early 1980s when interest rates skyrocketed and an ARM loan was the only way to qualify many first-time home buyers, in recent years ARMs have become the loan of choice for a large portion of the U.S. population. In fact, they are particularly popular among more sophisticated, higher- income borrowers.

The more sophisticated the borrower, the more likely he or she is to elect an ARM. In fact, over the last 12 years, approximately 20% of all mortgages have been ARMs, while about 50% of all jumbo mortgages (loans exceeding $333,700) are ARMs.

Myth #6:ARMs don't offer flexible terms, maturities, or pricing

REALITY: The truth is that ARMs offer more flexible terms, maturities, and pricing than 30-year fixed-rate mortgages. A borrower is more likely to find ARM loans that offer interest-only options, something almost unheard of with 30-year fixed-rate loans. ARMs come in all shapes and sizes, with a range of margins, indexes, interest-rate caps, pledged-asset options, prepayment options, and even modification privileges.

Myth #7:ARMs must be amortized just like fixed-rate loans

REALITY: Nope, ARMs do not have to be amortized over 15- or 30-year periods like fixed-rate loans. For instance, ARMs are available on an interest-only basis, where the borrower can minimize cash outflow, putting the mortgage principle component into alternative uses. Borrowers should look for a lender that does not charge a premium for the interest-only option. Moreover, the borrower can make principal payments at any time without incurring a prepayment penalty.

Myth #8:ARMs must be paid off over 30 years

REALITY: Wrong! An ARM can be paid off at any time the borrower desires, usually with no prepayment penalty.

Myth #9:A 30-year fixed mortgage can't be refinanced into an ARM

REALITY: Wrong again! A 30-year fixed-rate mortgage can most definitely be refinanced into an ARM loan.

Myth #10:All ARMs are the same and all mortgage lenders offer the same types of ARMs with the same terms

REALITY: All ARMs are not the same, nor are all lenders. ARMs are one of the most creative, flexible loan choices ever to have been created. The ideal ARM is one that affords the borrower maximum flexibility without imposing extra costs associated with that flexibility.

Selecting the right kind of mortgage, whether an ARM or a 30-year fixed-rate mortgage, can best be determined by a homebuyer and the client's financial advisor in the context of the client's overall financial situation. Look for an ARM lender that offers competitive rates, no origination fees, low lender fees, low margins and caps, commonsense underwriting, no-extra-cost interest-only terms, pledged asset programs, and a modification program. If that lender also never sells its loans to other investors, you've found a winner.

Joe Badal is CEO of Thornburg Mortgage Home Loans, Inc. the mortgage lending subsidiary of Thornburg Mortgage, Inc., a single-family residential mortgage lender with $22.4 billion in assets focused principally on the jumbo segment of the mortgage market. He can be reached at plusprogram@thornburgmortgage.com.

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