GRAND RAPIDS — Cornerstone Home Loans owner Steven Vanderwey had reason to disagree with a report by Suze Orman he caught recently on MSNBC.
“She was complaining that (Federal Reserve Board chairman Alan) Greenspan was saying banks should offer more Adjustable Rate Mortgage (ARM) products,” Vanderwey said. “She thought that was ridiculous, but I really don’t think it is. ARMs have always been a better and more cost-effective way of financing a home.”
According to definitions by the Federal Reserve Board, the interest in a fixed-rate mortgage stays the same throughout the life of the loan. But with an ARM, the interest rate changes periodically, usually in relation to an index, and payments may go up or down accordingly.
Lenders generally charge lower initial interest rates for ARMS than fixed-rate mortgages. The financial burden on the borrower is less initially, and the overall cost could be much less over the course of the loan. However, there is a risk that if interest rates don’t remain steady or lower, the borrower will be faced with higher monthly payments and a costlier loan.
“To me, getting a 30-year fixed makes very little sense,” Vanderwey said. “People do it because they’re afraid. Whenever there is a fear factor, people don’t look at the alternatives rationally.
“I ask my customers that if someone could sell them an insurance policy that would guarantee the rate doesn’t go up more than 1 percent, would you take it? Most of the time they decide no.”
Essentially, Vanderwey argues, a fixed-rate loan is just that: an insurance surcharge against higher interest rates.
Although there are literally hundreds of different ARM products available, the most popular involve five-year and seven-year terms. On a 30-year mortgage, the interest rate is fixed for the first five to seven years of the loan. The initial rate is usually 0.75 to 1 percent lower than that of a comparable fixed-rate loan.
After five or seven years have passed, the rate will begin to adjust, using either the one-year Treasury bill or LIBOR as an index. The margins from that index vary from 1 percent to as high as 3 percent, and there is usually a cap of no more than a single percent annual adjustment. (When preparing to sign any mortgage, borrowers should read the fine print, because large margins or caps can quickly erase many of the benefits of an ARM.)
Generally speaking, according to Vanderwey, the ARM will provide significant savings provided the interest rate is not more than 1 percent higher than at the end of the fixed period.
A recent Cornerstone example was a $160,000 loan with a 0.75 percent savings that allowed the borrowers to pocket $100 a month for seven years. A newlywed couple, the $8,400 savings will be appreciated through the early years of raising children.
Steve Jongsma, assistant vice-president of residential mortgage for National City, is seeing more clients take advantage of ARMs for similar reasons. He was surprised to learn earlier this month that more than 40 percent of National City’s current loan volume is ARM products. The West Michigan market, however, is currently only 15 percent to 20 percent ARM.
“In this area people are more conservative,” Jongsma said. “They just want to take the 30-year fixed so they can sleep every night knowing that their payments are going to stay the same.”
Jongsma has suggested a creative use of the ARM for many of his clients, including many times an interest-only payment for the initial fixed period of the loan.
One example included a family who was about to put several children through college.
A refinance on an interest-only payment allowed the family to shrink its home equity by taking out $100,000 on a $120,000 home. The family then put that cash into a cash-value life insurance policy — diverting assets that count against financial aid into those that do not.
This allowed the children to qualify for financial aid, while the parents pay a substantially lower house payment until the children have passed through college.
“The reason I myself would do it is for flexibility,” Jongsma said. “Fewer and fewer people now have jobs where they get a consistent and regular paycheck, plus there are unexpected things in life.”
With an interest-only ARM, borrowers can pay on the principal each month — but don’t have to. For workers like Jongsma, live on commission — or others who receive substantial quarterly or annual bonuses — an ARM allows for payment flexibility. In the profitable months, borrowers can pay a chunk of the principal; in tight months, there is no worry about missing a payment.
Also, emergencies found often in automobile and home repairs will be easily managed.
There are two other arguments for ARMs.
According to Vanderwey, the “historically low” interest rates of today’s market are not significantly different from historic rates.
“It depends on how you measure history,” he said. “If you look at the last 25 years, an ARM would have been a better choice at any period of time. If you look at rates over a 100-year period, there has only been one sustained period of time when rates were over 7 percent.”
Vanderwey explained that only during the late 1970s and early 1980s have interest rates reached that high, due to a period of high inflation and poor federal policy in managing the inflation. Today the government is much more aggressive at managing inflation.
“Some things that affect inflation are war, rising fuel prices and uncertainty about elections,” he said. “We’ve had all those in the past few months and interest rates are still low.”
As both Jongsma and Vanderwey agreed, there is an even stronger insurance policy built into ARMs. There isn’t much likelihood that a borrower will keep the loan for its duration. The life of the average mortgage is less than five years.