How to Explain Adjustable Rate Mortgages to Your Client

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Explain Adjustable Rate Mortgages

Buyers can easily get overwhelmed by the number of financing options available to them. Your job, as a mortgage loan officer (MLO), is to make sure that your clients obtain the type of loan that is best suited for their financial situation and their goals.

Adjustable rate mortgages can look very attractive to home buyers, but there are pros and cons. You’ll need to be able to guide your clients to the right solution.

What is an Adjustable Rate Mortgage?

The ARM, or adjustable rate mortgage, is a home loan with an interest rate that changes based on market conditions. Beginning interest rates on an ARM are typically lower than a 30-year fixed mortgage.

When the interest rate on a loan is fixed, it doesn’t change throughout the life of the loan. As a result, the monthly payment stays the same. However, the payments on an ARM will change when the interest rates change – the monthly payment could go up or down.

What Type of ARMs are Available?

Banks can offer a variety of ARMs. The type is typically shown like this: 7/1 ARM. That means that the loan will have the same interest rate for the first seven years. After that, the loan’s interest rate adjusts once per year. Other typical ARMs include 3/1, 5/1, and 10/1. But, you also need to know about the ARM’s terms.

  • Index: The lender uses an economic index to determine whether the ARM’s interest rate needs to go up or down. Typically, lenders use the one-year LIBOR, or London Inter-Bank Offer Rate, to determine changes. If the LIBOR is higher than it was when the loan closed, the interest rate will go up and the same is true if the LIBOR is lower.
  • Initial Cap: This represents the highest increase that the lender can apply after the fixed period.

Periodic Cap: Some ARMs have this limit for increases that may change from year to year.

  • Lifetime Cap: All ARMs have an upper limit for interest rate increases over the life of the loan.

If you see an ARM cap described as 2/2/5, it means that the interest rate can adjust up to 2 percent after the fixed period, up to 2 percent for each succeeding period, and the interest rate increases over the life of the loan can’t be more than 5 percent.

How to Counsel Your Client about ARMs

ARMs are attractive to buyers because the initial payment is lower. Buyers may want an ARM to purchase a more expensive home than they could otherwise afford. But, your buyers need to be realistic, and should only consider an ARM in the following situations:

  • They intend to sell the home or refinance before the end of the initial fixed rate period.
  • They know that their income will rise in the initial fixed rate period, meaning that they will be comfortable paying the higher monthly fee if the rate goes up, and they will be in a strong position to refinance if rates go down.

Given that it’s difficult to predict what interest rates will be three, five, or 10 years in the future, a buyer is taking a gamble. What if their plans to move don’t work out, or the increase in income doesn’t happen as they’d anticipated? They may actually be forced to sell the home if they can’t afford the increase in payments or refinance at a lower rate.

Consider a worst-case scenario. If they started by financing $200,000 at four percent, the monthly payment would be $954.83. But, by the time the interest rate increased five percent, the payment would shoot up to $1,609.25.

Whether you’re already an MLO, or if you’re in the process of learning to become a mortgage loan officer, you’ll find that it’s not just all about the numbers. You’ll need to guide your clients to the right solution for them – this is how you’ll succeed and retain clients.

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