Warning – ARM loans

Hi Boys and Girls,
There has been a lot of interest over here in the U.S for A.R.M Loans- “Adjustable Rate Mortgage”. I was talking to my sister-in-law at Xmas about them (she works for a small Victorian country town Mortgage Broker) and she was unfamiliar with them. This was a surprise to me, so I thought I would give everyone the ‘heads-up’ on this product if you haven’t heard of it.

Basically how they work is the lender provides a loan with a cut-rate of interest for the first 3-5 years. At the end of this period the interest rate reverts back to the normal market variable interest rate.

For example; the current variable interest rate is say, 6.5%. The ARM rate is say, 3.5-3.99% for 3 years, then reverts to 6.5% (assuming the rate is the same at that point in time). Obviously, the repayments in the first 3 years are much lower than they would be normally. This allows people to get a loan where they might not qualify normally, or allow them to buy a more expensive property.

The intention behind this loan is honourable – the person who takes out the loan is supposed to save money towards the home because of the cheaper repayments at the start, and assumes that over time the property will go up in value.

In reality what has been happening over here is the mortgager spends the money on ‘doodads’ or paying off credit cards so they can max them out all over again.

The problem that occurs is when the loan reverts from the ‘introductory rate’ to the normal interst rate. Most times the mortgager hasn’t improved their financial situation, and can’t cover the increase in the loan repayments, which can in some cases be over $1k per month.

Meanwhile, the difference in the interest rate has been ‘capitalising’ over the first 3-5 years of the ‘introductory rate’, and so the loan has increased. Say the mortgager starts with a loan of $300k, at the end of the introductory rate period the loan is now $350k – they now owe more than they started with!

The situation that has occurred here in the U.S is that these ARM loans have reverted back to the normal rate at the end of the boom, so now there are literally tens of thousands of people with loans they now can’t afford, the loan has increased by thousands and the property which the loan is attached to is worth less than what they bought it for. Foreclosures are predicted to rise sharply in the next 1-2 years. Good for the cashed-up investors.

If these loans haven’t arrived in Aus already, they will soon, and I want you all to be aware of the dangers with them.

Some of you may say that it is not a lot different to an Interest Only loan that reverts to a P&I loan, but where these loans are more dangerous than an I.O loan is that the unpaid interest is capitalising on the loan.
The I.O loan simply reverts to the normal P&I loan after a time, but the loan balance hasn’t increased.

In my limited view there is not really much of an upside to these ARM loans – other than for the Mortgage Brokers and Lenders who set up the deal. I will be happy to be proved wrong of course.

Cheers,
Marc.
[email protected]