Payment Shock You May Face with an Adjustable Rate Mortgage (ARM)

As we know, adjustable-rate mortgage (ARM) is a loan with an interest rate that is fixed for a set period of time and then adjusts thereafter. During that period of time, the interest rate (that is also the introductory rate) is usually significantly lower than what consumers can get with a fixed-rate mortgage. For this reason, ARMs hold many homebuyers’ appeal.

Indeed, if you are planning to move out of your home or refinance your loan in the near future, an adjustable-rate mortgage could be a great option.

However, these ARMs are not good choices for everyone. When ARM adjusts, the increase in interest rate and thus in payment can be quite significant. Many homeowners don’t keep a close eye on the market rates that are the basis for their ARM rate, so they could get an unpleasant surprise when the higher mortgage bills arrive. The amount of the increase can range from an unpleasant surprise to a payment that breaks your budget. This is so-called payment shock.

In essence, payment shock is any considerable increase in monthly liability that could result in an increased risk of loan default. Simply put, the more you need to pay out each month to your lender, the higher the chance you will be unable to make a payment. Actually, many adjustable-rate mortgage products, such as payment-option ARMs, carry a great deal of payment-shock risk.

Let’s assume you have a 30-year ARM of $150,000 with an introductory rate of 3.5% and the interest rate will adjust to the fully indexed rate of 5.5% in the second year. Fully-indexed rate is equal to the margin plus the index. It is the actually rate that an ARM is based on. In this case, your monthly payment would be about $674 in the first year. After the ARM adjusts, your monthly payment would be about $817 in the second year.

As the example shows, even if the index rate remains the same, your monthly payment would increase from $674 to $817.

Suppose that the index increases 1% in the second year. That is to say, the interest rate on your ARM will rise to 6.5%. Then your payment in the second year would be about $907. It is an increase of $233 in your monthly payment. That’s really a lot, right? You know if your mortgage payment increases greatly at a rate adjustment, payment shock may occur as you wouldn’t be used to shelling out such a large amount of money each month.

Be noted that if you have a payment option ARM, payment shock may also occur when the loan is recast. Additionally, it may also happen on an interest-only mortgage when the interest-only period expires. Overall, payment shock can be the result of several things, including:

• The expiration of an initial or temporary start interest rate (sometimes known as a teaser rate)

• The end of a fixed-interest rate period

• The end of an interest-only payment period

• An increase in the fully indexed interest rate, thus increasing your monthly payment

• The recasting of a payment option ARM

Speaking of teaser rates, you should be aware that ARMs are often advertised with an initial rate that is lower than its fully indexed ARM rate for the first year or first few years. This rate is also known as discounted rate, start rate or teaser rate.

The rate is often combined with large initial loan fees (sometimes called discount points). This means your lender may offer you an opportunity to buy discount points for your loan. Typically, one point equals to one percent of the loan amount. You can choose to pay these points in exchange for a lower interest rate. However, realize that the lower interest rate may not exist when the loan adjusts.

So, if a lender offers you a loan with a low initial rate, don’t assume that means the loan is a good one for you. You should consider carefully whether you can afford higher payments in later years when the loan adjusts.

Here, I quote an example from the Federal Reserve Board that compares several different loans over the first 7 years of their terms. The payments shown are for years, 1, 6, and 7 of the mortgage, supposing you make interest-only payments or minimum payments.

• 30-year fixed mortgage: Your monthly payments are fixed at $1,199.10 over the life of the loan

• 5/1 ARM: Your monthly payments are $954.83 for the first year, $1,165.51 for the 6th year and $1,389.51 for the 7th year

• 5/1 interest-only ARM: Your monthly payments are $666.68 for the first year, $1,288.60 for the 6th year and $1,536.29 for the 7th year

• Payment-option ARM: Your monthly payments are $739.24 for the first year, $1,603.10 for the 6th year and $1,708.22 for the 7th year

Do you find that your ARM payments can change quite a lot over the life of the loan? So, although you could save money by taking advantage of low introductory rates in the first few years, you typically cost more money in the log run than you would with a fixed-rate mortgage. Plus, even though you plan to refinance your adjustable-rate mortgage, you will have to deal with a lot of closing costs resulting from a refinance.

However, a main point you should know is that many banks and mortgage companies have a certain limit on payment shock that they need to allow. Usually, the payment shock limit may be set at 200%. This means your monthly payment cannot be more than twice as much as your current housing payment. For example, if your current monthly payment is $8,000, your max mortgage payment cannot exceed $1,600, or it may be subject to review or denial.

Tip: Anyway, for any financial decision, including the choice of an ARM, you should carefully take into account the risk versus the reward. Also, make sure to identify and measure risks including payment shock through insightful analysis. You know in most cases, these risks can be managed or avoided, when recognized and measured.