Distinguish Regret from Actual Loss
No matter which mortgage you choose, you can’t know its true cost until after the fact, but you can forecast likely costs and benefits under a variety of reasonable (or even unreasonable) eventual outcomes. Only after you make these calculations can you decide which choice looks best. Gut reactions like, “We don’t want the risk of an ARM” cost you plenty. Run the pertinent numbers, then choose.
All mortgages present risk in an economic sense—either out-of-pocket or opportunity costs. You gain when you vanquish emotions and focus on the figures. You may discover that some type of ARM saves you money and helps you qualify for a larger loan. Or if you’re an investor, the ARM might help your property yield a positive cash flow.
Rate Increases and Wrecked Budgets
Sometimes ARMs appeal to the wrong types of borrowers. During periods of high 30-year fixed interest rates, ARMs permit borrowers to obtain larger loans than they otherwise could. A lower qualifying interest rate when combined with higher qualifying ratios (a feature of some ARMs) attracts marginal borrowers. Because they’re struggling from the beginning, unexpected payment increases (called “payment shock”) push these types of borrowers into financial distress.
Indeed, in reaction to the recent uptick in ARM defaults, many lenders have decided to qualify ARM borrowers at the fully indexed rate—rather than the teaser rate. Even stricter, some lenders now qualify ARM borrowers at the maximum possible ARM contract rate.
Payment Shock
By the time you agree to accept an ARM, your loan rep should have eliminated the possibility of payment shock. The loan rep should show you a monthly payment schedule outlining the maximum amounts you could ever pay, and the dates when those maximums payments could go into effect. If your payments at some time did reach those levels, you could not justifiably claim to be shocked any more than Claude Rains when he discovered gambling operations in the back room at Rick’s cafe in Casablanca.
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