Should You Get An ARM?
Let's look at the pros and cons to ARMS and the different options available within this category of home loan.
The lender assumes the greater risk with a fixed rate mortgage because no matter how high interest rates go, the borrower's interest is locked in for 30 years. That's why fixed interest rate loans have higher interest rates. ARMs, however, put the risk squarely on the borrower.
ARM qualifying rates are less than fixed-rate loans, so lenders also offer ARM borrowers more liberal qualification ratios. For instance, with a fixed-rate loan a lender might allow 28 percent of a borrower's gross monthly income for the payment of principal, interest, taxes and insurance. But with an ARM the qualifying ratio is usually higher, say 33 percent. Put these two factors together - lower initial qualifying interest rates and more liberal qualifying ratios - and you can borrow quite a bit more than you would with a fixed rate loan.
So how do ARMs work? The ARM interest rate is determined by an "index" that fluctuates with economic conditions and a "margin." A typical rate cap on an annual basis is 2 percent, or 2 percent above or below the previous year's rate.
An interesting ARM option is called the LIBOR (London Interbank Offering Rate) ARM. The London Interbank Offering Rate is the rate that international banks based in Europe charge each other for overnight funds. Now here's the kicker - LIBOR ARMs often have a much lower interest rate than others. The interest rate on an ARM has a lifetime cap of 13 percent, and monthly payments can't rise more than 7.5 percent annually.
A LIBOR ARM may be for you if you
- Are looking to minimize your monthly payment.
- Are seeking to lower your interest rate and monthly cash flow.
- Want to take advantage of the equity in your house. This is a good refinance program for those who want to consolidate consumer debt such as credit cards.
Any ARM is a good idea if
- ARM interest levels are significantly below fixed-rate interest charges
- You won't be staying in the house for more than five years (especially if you have a locked-in rate for the first three, five or seven years)
- You anticipate a higher income in the future (such as a young professional just starting out)
ARMs are not a good idea if
- Initial rates are comparable to fixed-rate loan rates
- High closing costs offset the low interest rate
Conforming vs. Non-conforming Loans
Conforming loans offer terms and conditions that follow guidelines set forth by Fannie Mae and Freddie Mac. Nonconforming loans, also known as jumbos, are for borrowers whose situations do not "conform" to strict Fannie Mae/ Freddie Mac underwriting guidelines.
Non-conforming loans are much easier to qualify for than conforming loans. They also close faster, have reduced or no reserve requirements, allow expanded use of loan proceeds and provide higher levels of cash out for debt consolidation.
Circumstances that could prevent you from conforming financing include:
Self employment; complicated tax returns; if you do not wish to disclose or document your income; high debt ratios; current or previous credit difficulties; if you want to repay federal tax liens; if you want to recoup equity from your homestead.
Interest-Only Loans
You may want an interest only loan if you:
- Are disciplined with money
- Aren't taking on more than you can handle comfortably
- Expect your income to rise sharply in the next five years
- Have an irregular income (like commissioned sales) so that the lower payment is manageable during lean periods and when the money is coming in can pay down the principal
- Are content to let rising markets build your equity for you
- Are confident that home prices will continue to rise
You don't if you:
- Have a lot of consumer debt you can't get a handle on
- Plan on being in your house longer than the interest-only period
- Are undisciplined with finances
- Are borrowing a small amount
- Plan on spending the extra cash on "discretionary" items
- Plan to sell or refinance before the interest-only period ends
- Want to lock in today's low interest rates
