Despite the lessons from the housing bubble crash, some home loan borrowers are still betting on a rosy future and taking on adjustable rate loans which have historically proven to be risky. These home buyers aren't average borrowers though. They are wealthy consumers taking out jumbo loans with short-term adjustable rates. Although the 30-year fixed mortgage rate continues to be the most popular mortgage product among everyday Americans, the use of adjustable rate mortgages (ARM) has been going up.
Many ARM borrowers wish to take advantage of current relatively low rates, either hoping rates will stay low in the future or hoping that refinancing when rates go up will be a fast and easy solution. The wealthy buyers behind the surge in ARMs with short adjustment periods may be looking for other advantages to save money.
What is an adjustment period?
The adjustment period is the length of time the ARM remains at the original rate until it is due to reset with the index rate. When the term is up, the rate is determined by adding a predetermined amount to the index rate, which is often based on something called LIBOR, an acronym for the London Interbank Offered Rate. A change in the interest rate can have a significant impact on the amount of the monthly payment on the loan.
Although it is not a ratio, ARMs are typically designated with two numbers separated by a slash. The first number is the length of the adjustment rate, and the second is the interval at which the rate will continue to be reset. For example, a 5/1 ARM is a loan with an adjustment period of five years, with a reset to the index every year thereafter. The length of the initial period can range from two to seven years, with lower rates offered for shorter adjustment periods.
The risks and rewards
A good portion of the failed loans during the collapse of the housing bubble were ARMs; buyers often couldn't afford to make monthly payments once the new rates were applied. While many of these were subprime borrowers with poor credit history and unverified income sources, others lost homes after they lost jobs as other sectors of the economy declined.
However, there may be a different story for wealthy buyers of high-end homes, provided their income sources remain strong. During the first eight months of 2013, the number of borrowers opting for much riskier 1/1 ARMs increased dramatically. About 75 percent of jumbo ARMs originated by private lenders were written with one-year adjustment periods.
The movement toward 1/1 ARMs was not limited to the purchases of new homes. Those who refinanced private jumbo loans also overwhelmingly chose 1/1 ARMs, which comprised 96 percent of all refinance deals on jumbo loans made through private lenders.
Why the increase? It's the appeal of taking on a loan which will have a known interest rate for one year at a ridiculously low initial rate. Some of these short-term adjustment period ARMs start as low as 2.5 percent for that first year.
Money for other things
Some of these borrowers with a high net worth may be betting on interest rates remaining low, but others are quite literally banking on lower mortgage payments. The savings racked up in the first year of a low-rate mortgage can be rolled into other investments with higher returns. A 1/1 ARM buyer with a 2.5 percent rate could save $10,000 in the first year over taking a 30-year fixed-rate mortgage with a 4 percent rate. That's a savings amount which could be earning money if invested wisely—or spent on lavish parties and expensive champagne.
With the popularity of ARMs on the rise, time will show whether or not these borrowers have made wise financial decisions or took risks they couldn't afford. The risks may be lower for wealthy buyers, but lessons learned from the collapse of the housing sector in 2008 may already be forgotten by some.
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