Analyzing your ARM risk

By Melissa Wirkus

Adjustable-rate mortgages or ARMs have been making the news lately for a variety of reasons. This is not a new type of mortgage product, but rather one that has been around for a while but is due for some interesting changes.

Option ARMS are different from traditional mortgages in that they offer a very low fixed initial interest rate, and then the loan “adjusts” after a certain amount of time to meet the current market rates. Thousands of these loans are set to adjust this fall, meaning higher monthly payments for an overwhelming amount of people. This means that there could be an overwhelming amount of people in foreclosure in the near future because they could not make their new higher monthly payments.

A September 7, 2006 article by Holden Lewis of Bankrate.com, “5 ways to assess risk of your option ARM,” gives borrowers some vital information on analyzing their particular situation.

The first step in analyzing your ARM risk is actually understanding this type of mortgage. Mortgages can be difficult to comprehend and understand in general, and an ARM is one of the more difficult ones to get the gist of.

“An option ARM is an adjustable-rate mortgage that gives the borrower four choices of a payment each month. The borrower can pay the amount necessary to pay the loan off in 15 years or in 30 years. The borrower can pay only the interest charged in the previous month. Or the borrower can make a minimum payment that doesn't even cover the interest, so that the loan balance increases.”

Only paying the minimum payment for an extended period of time is the number one way that borrowers run into trouble. “If you have been making minimum payments most months, you're not paying down your debt and might, in fact, be increasing it.”

If they are having a hard time paying the lowest possible amount, then how in the world will they afford their payments when it adjusts?
If you exaggerated your income on your loan application then you are probably at a very high risk for not being able to keep up with your payments and will either default or go into foreclosure.

If you are approaching your principal cap, you could also be heading for trouble. Paying only the minimum payment every month results in negative amortization. Lenders do not let negative amortization go on forever, so they set principal caps in place.

“Most option ARMs have a principal cap of 110 percent, meaning that if your loan balance reaches 110 percent of the initial loan amount, you'll suddenly have to start paying down the loan balance. Before you reach the principal cap, the minimum monthly payment can rise only a maximum of 7.5 percent a year. After you reach the principal cap, that limitation is thrown out the window. The minimum monthly payment can more than double in some cases.”

The one other thing to be aware of if you have an ARM is if home prices in your neighborhood are falling. Right now, the housing market is cooling down, and many are expecting home appreciation to further decrease in the next few months.

“The danger with falling houses prices is that your home's market value could fall below the amount you owe on it. That puts you in a position where you can't afford to refinance the mortgage or sell the house unless you have enough cash lying around to make up the difference. And if you have that much cash, why are you in over your head with your mortgage?”

Option ARMs are good for a wide variety of people, but they can also be detrimental to the people that fall into the risk situations and categories mentioned above.

“Lots of people are fine candidates for option ARMs. The loans are well-suited for people whose incomes vary from month to month (think small-business owners and salespeople on commission) and people who get a big chunk of their income via bonuses (your boss's boss's boss, investment bankers and sundry corporate chieftains).”

If you feel as if you are getting in over your head with this loan, there are a number of things you can do.

“To stay out of trouble, there are a number of things you can do if you have an option ARM: Make at least the interest-only payment, refinance the loan or sell the house and pay off the mortgage.”

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