As tempting as it might be to save a few bucks a month by opting for an adjustable rate mortgage, consumers need to do their homework in this ultra-low rate environment.
Some first-time homebuyers, for example, tend to favor the lower upfront payments on the theory that they’re moving into a starter home anyway. And they believe they’ll be moving sooner than you’d imagine in five or six years.
But will they really move? Will they be taking on more risk here than they realize? Will they be socked down the line with monthly payments that they really cannot afford?
“With an ARM, the interest rate and monthly payment may start out low,” according to the newly revised Consumer Handbook on Adjustable Rate Mortgages produced by the Consumer Financial Protection Bureau.
“However, both the rate and the payment can increase very quickly.”
The booklet is given to potential borrowers by lenders when they’re reviewing the option of an ARM and spells out many details.
If you take out a 5/1 ARM, for example, it’s important to realize that your initial rate will last five years but your mortgage rate could change every year after that. And the risk is that it could go up.
It’s also essential to know exactly when any temporary “teaser” rates might end.
“When the teaser rate ends, your loan takes on the fully indexed rate,” the booklet notes. “Don’t assume that a loan with a teaser rate is a good one for you. Not everyone’s budget can accommodate a higher payment.”
The revised booklet highlights a comparison table to spell out the differences between a fixed-rate mortgage and an adjustable rate mortgage.
“Right now, we’re in a very low interest rate environment but that may not be the case for the long term,” said Kathy Kraninger, director of the Consumer Financial Protection Bureau.
Kraninger said borrowers also need to understand how a given mortgage is pegged to an index, such as London Interbank Offered Rate or LIBOR. The LIBOR index is being phased out by the end of 2021 and that could impact what you pay going forward in some way.
The change is taking place after a controversy about some cases of market manipulation relating to LIBOR where some banks intentionally misreported rates. The updated CFPB booklet also removes references to the LIBOR benchmark index.
“Lenders do have to alert consumers if their loan is indexed to LIBOR that there is going to be some transition in rates,” Kraninger told me in a phone interview.
And it’s not just ARMs. LIBOR is the benchmark index to determine the interest rate that consumers pay on some credits cards, home equity lines of credit, reverse mortgages and private student loans.
Going forward, Kraninger said lenders must ensure that the consumer’s interest rate that’s calculated using a replacement index will be “substantially similar” to the rate that would have resulted using the LIBOR index.
Greg McBride, chief financial analyst at Bankrate.com, said consumers need to review their options carefully, if considering an ARM at this point.
“With fixed mortgage rates at record lows, why take the risk of an adjustable rate? The average 30-year fixed rate is 3.47% and the average five-year adjustable is 3.45%, so there is no real advantage of taking an adjustable rate,” McBride said Thursday.
“Jumbo borrowers are more likely to go the adjustable route for a couple reasons — credit is particularly tight on jumbo fixed-rate loans, and higher net worth jumbo borrowers often use adjustable rate loans as a way to maximize cash flow, not as an affordability mechanism.”
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Again, though, make sure you understand how things can fluctuate in the years ahead.
“If you take an adjustable rate mortgage, look closely to see what index the rate will be determined on in the future,” McBride said.
“LIBOR is going away and there is a lot of uncertainty about what will happen with LIBOR-indexed loans, particularly which index will the loan switch to and what will that mean for future rate adjustments,” McBride said.