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September 20, 1999
"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.
Copyright Jack Guttentag
2002
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