“The cautious seldom err.” – Confucius
I’ve bought properties with fixed-rate, adjustable, assumable, 30-year, and 15-year mortgages. They all have their plusses and minuses. But right now, with interest rates rising, ARMs (adjustable-rate mortgages) are soaring in popularity. So it may be a good time to spell out some of their advantages — and warn you of a few hidden dangers.
On the plus side, because ARMs typically have lower initial interest rates than do fixed loans, they can help you qualify for a home you may not otherwise be able to buy. They can also save you money in the early years of a mortgage. But, in the long run, they can cost you big time.
Here’s what you need to know:
Adjustable-rate loans allow banks to adjust the interest rate on a loan (up or down) according to a predetermined index and margin. An index that is commonly used is the one-year Treasury bill. The margin is a percentage rate that is added to the index. So if, for instance, your adjustment date comes up and the index is 3% and the margin specified in your loan is 2.5%, your new interest rate is 5.5%.
ARMs come in many different flavors. The most common have a fixed interest rate of one, three, or five years and then start to adjust every year. Generally, the shorter the initial fixed term, the lower the initial interest rate.
Assuming points and fees on these are the same, you’ll find that lower-rate ARMs will have less risk if you’re not going to hold the property for a long period of time.
For instance, if you’re confident you’re going to “flip” a property (buy and sell it) in a year or less, the 2% or so you save on a 1/1 ARM (one that has a fixed interest rate for the first year and then adjusts annually) vs. a fixed-rate mortgage could be a good deal. But if the flip doesn’t work out and you end up holding onto the property, you may find yourself paying higher mortgage payments every year if interest rates continue to rise.
In addition to the risk of rising mortgage payments, there’s another danger with some ARMs — a danger that’s overlooked by most homebuyers. That’s the risk of negative amortization.
“Amortization” comes from the Latin “mors,” meaning “death.” So amortization means to “kill off,” or pay down, a loan. With a normally amortized loan, your balance due decreases with each monthly payment. Negative amortization is the reverse of this.
This is a situation in which your loan balance can be going up each month even though you’re making all your required monthly payments on time. Negative amortization comes into effect when a loan has different periodic payment caps and interest-rate caps. Even though your loan might stipulate that your payment can go up a maximum of 7.5% a year, for example, there’s no such limit on your interest rate.
That means your mortgage payment might jump from $500 to $538 at your first adjustment date. But your interest due each month could jump to $550 or $600 or more!
So what happens with the unpaid interest? It gets tacked on to your loan balance — and it also begins to accrue interest. Suddenly, even though you’ve been making all your required payments, your total amount due could go up by thousands of dollars in a year.
By law, most lenders must limit negative amortization to no more than 125% of the original loan. In a worst-case scenario, that means if you borrow $100,000, you could end up paying back $125,000 in principal — plus rising interest on that $125,000.
If you get in this situation, you can avoid the pitfalls of negative amortization by making more than the minimum required payment each month — by making sure you pay at least enough to cover all interest due for that month. (This same strategy, by the way, works when it comes to dealing with credit-card debt too.)
Still, the best way to avoid this situation is to keep from getting into it in the first place.
How do you do that?
1. Tell your lender you’ll only consider ARMs that do not have the potential for negative amortization. Also, read the Loan Disclosure Letter when you apply for the loan and the Adjustable-Rate Note before you sign it. Look for clauses referring to amortization and for phrases like “Limit to My Unpaid Principal; Increased Monthly Payment.”
2. If you’re confident you’re going to own your home or investment property for many years, try to get the best fixed-rate loan you can find.
3. Even for property you intend to hold for only a few months or years, consider ARMs with the longer fixed initial terms — just to be safe.
4. Consider an ARM with potential negative amortization only if (a) it has a much better rate than non-neg-am ARMs and (b) you are very confident that you will be selling the property before or not long after the first adjustment date (when negative amortization could first occur).
5. If possible, get a conversion clause. Some ARMs let you convert your loan at the first adjustment date to a fixed-rate loan at the rate then in effect. Most such ARMs don’t charge anything for that clause — unless you decide to use it. But you may find that to be much cheaper than refinancing.
(Ed. Note: Justin Ford is the editor of Main Street Millionaire, ETR’s real-estate investment success coaching program.)