Mike Larson: Evaluate pros, cons of ARMs
Mortgage Q and A
December 1, 2006
Q. The media has raised concerns of late about adjustable rate mortgages and the risk that interest rates will not decline. I have heard others say that in Steamboat’s real estate market, I should not worry about getting an ARM because the appreciation of my home will offset a rise in interest rates. What are your thoughts about using an ARM to purchase property in Steamboat Springs?
A. Like any loan program, adjustable rate mortgages have their pros and cons. They are best suited for those borrowers who a.) have a valid need for a low initial payment; and b.) can deal with the possible consequences of their payment going up in the future.
Three initial points worth noting about adjustable rate mortgages:
A. An ARM is just another tool in the box – to use it properly you must understand what it does and what it does not do.
B. Not all ARMs are the same – there are good ARMs and there are bad ARMs.
C. ARMS are subject to protective rate caps – most have both yearly and lifetime caps.
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ARMS work best in the following situations:
1. When you think you will keep the property no more than five to seven years.
2. When the local market is experiencing strong appreciation and you expect it to continue.
3. When adjustable short-term rates are significantly lower than long-term fixed rates.
4. When you expect to have significantly higher income in the future.
5. When your income is subject to large fluctuations.
Conclusion – I like five- to seven-year ARMs when rates are relatively low (compared to fixed rates) and at least two more of the above five factors are in place. If a borrower can tolerate a little risk, and wants to buy as much house as possible, I often advise them to start with an ARM (five- to ten-year ARMs are safest) and then in three to five years, before their rate starts to adjust, try to catch a rate dip and refinance into a fixed loan.
Q. I want to buy a home in Steamboat Springs. I have a good income, but I don’t think I can come up with the down payment for a conventional loan. What are my options?
A. Surprisingly, there are a number of viable 100 percent loan programs out there. If a borrower has decent credit and enough income to support the debt, a good lender can often find a mortgage loan despite the lack of down payment. Basically, if a borrower can’t come up with 20 percent down he will have to do one of two things. Either pay mortgage insurance or borrow 80 percent on the new first mortgage and borrow the remainder on a second (usually higher rate) mortgage. There are pros and cons to each approach. In a market experiencing rapid appreciation, like Steamboat’s, I usually end up recommending that the borrower go with mortgage insurance. Second mortgages can take a long time to get rid of, whereas mortgage insurance can go away in as little as two years.