Peace of Mind With an Adjustable Rate Mortgage?

September 20, 1999, Reviewed February 12, 2011

"I was hoping that rates would go down and instead they went up, and now I need an adjustable rate mortgage to qualify and I'm terrified because I don't understand them. Is there any way I can take an ARM and still have peace of mind?"

Yes, you can have an ARM along with piece of mind, and I'll explain how presently.

The worst thing about the adjustable rate mortgages (ARMs) we have in the US is not that they are so dangerous but that they are so complicated. Ironically, the complications arise primarily out of efforts to make them less dangerous.

In the UK, Australia, South Africa and India, to mention just a few of the many other countries that use ARMs, they are much simpler. The rate is set for a short period at the beginning, after which the lender can change it at any time, by any amount for any reason. The only restriction on the lender is that the borrower be given reasonable notice of a rate change, usually 45 days.

I call this a "discretionary ARM" because the lender has complete discretion regarding the rate. The borrower is at the lender's mercy. With few exceptions, furthermore, countries with discretionary ARMs have only discretionary ARMs. Fixed-rate mortgages are not offered.

ARMs in the US differ from the discretionary ARMs that are the standard instrument in most other countries in three major ways:

The initial period during which the rate is preset is longer. Last month I was in South Africa where one of the banks proudly informed me that they were now offering "fixed-rate" mortgages. I subsequently learned that what he meant was that the initial rate could last as long as 2 years before lender discretion kicked in! In the US, initial rate periods run as long as 10 years.

Rate adjustments are automated. Rate adjustments on ARMs in the US are determined not by the board of directors of the lending institution but by a computer that has been programmed to apply a set of adjustment rules that are stipulated in the ARM contract. The central rule is that the rate will be adjusted on pre-specified dates to equal the value on that date of an interest rate index over which the lender has no control. The lender has zero discretion.

Rate adjustments are generally constrained. The great majority of ARMs in the US limit rate changes on any one adjustment date ("adjustment caps"), and also set a maximum rate over the life of the instrument ("lifetime cap"). There are some that have only adjustment caps, and some with only lifetime caps, but very few have neither.

These important features of ARMs in the US protect consumers but they also befuddle them. The educational materials on ARMs that the government requires lenders to provide to borrowers are not much help. Even those who master these materials have great difficulty bringing them to bear on the specific ARMs they are being offered. And many borrowers want to protect themselves without having to learn a lot of boring stuff for which they will have no later use.

To meet this problem, with Charles Freedenberg of DecisionAide Analytics, I have developed The Mortgage Professor's ARM Payments Calculator. It focuses directly on the major peace-of-mind concern of ARM borrowers, which is when and by how much their future payments might rise.

With calculators, you put information in ("inputs"); the calculator calculates; and then it gives you information back ("outputs"). The inputs to this calculator include a list of the features of your ARM that determine what might happen to the future payments. Even if you don't run the calculator, this handy list shows the information you should obtain from the loan officer, mortgage broker or web site. If you can't get it from that source, consider taking your ARM business elsewhere.

The second type of input is your own assumptions about what will happen to interest rates in the future. You can assume that interest rates won't change, that they will go through the roof ("worst case"), that they will trend up or down by some specified amount, or that they will fluctuate by some specified amount.

The "output" is a month-by-month amortization schedule over the life of the loan that shows all rate and payment changes associated with a specific interest rate assumption. Peace of mind comes from knowing that you will be able to deal with the payment changes that will come from the worst scenario you can imagine.

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