Question

"Why would you expect the cumulative total of interest payments under an ARM to be less than those under an FRM of the same maturity? Compare the risks to the borrower."

Answer 1

ARM & FRM:

The main benefits of an adjustable rate mortgage loan are that it has a low initial monthly interest rate, which results in a lower monthly mortgage payment when compared to a fixed rate mortgage.

Comparison of risks:

Risks in case of ARM:

Rising monthly payments and payment shock

It is risky to focus only on your ability to make I-O or minimum payments, because you will eventually have to pay all of the interest and some of the principal each month. When that happens, the payment could increase a lot, leading to payment shock. In the worksheet example, the monthly minimum payment on the option-ARM payment rises from $630 in the first year to $1,308 in year 6, assuming the interest rate stays at 6.4%. The monthly payment could go up to $2,419 if interest rates reach the overall interest rate cap.

Negative amortization

If you have a payment-option ARM and make only minimum payments that do not include all of the interest due, the unpaid interest is added to the principal on your mortgage, and you will owe more than you originally borrowed. And if your loan balance grows to the contract limit, your monthly payments would go up. For example, if your $180,000 loan grew to $225,000 (125% of 180,000), your payments would be recalculated.

Refinancing your mortgage

You may be able to avoid payment shock and higher monthly payments by refinancing your mortgage. But no one knows what interest rates will be in 3, 5, or 10 years. And if your loan balance is greater than the value of your home, you may not be able to refinance.

Prepayment penalties

Some mortgages, including I-O mortgages and payment-option ARMs, have prepayment penalties. So if you refinance your loan during the prepayment penalty period, you could owe additional fees or a penalty. In the Mortgage Shopping Worksheet example, the penalty is 3% in the first year, 2% in the second year, and 1% in the third year. In this case, you could owe $3,600 if you refinance in year 2. Most mortgages let you make extra, additional principal payments with your monthly payment. This is not considered "prepayment," and there usually is no penalty for these extra amounts.

Falling housing prices

If housing prices fall, your home may not be worth as much as you owe on the mortgage. Even if home prices stay the same, if you have negative amortization, you may owe more on your mortgage than you could get from selling your home. Also, you may find it difficult to refinance. And if you decide to sell, you may owe the lender more than the amount you receive from the buyer.

Risks in case of FRM:

There are varying risks involved for both borrowers and lenders in fixed-rate mortgage loans. These risks are usually centered on the interest rate environment. In a time of rising rates, a fixed-rate mortgage will have lower risk for a borrower and higher risk for a lender. If rates are rising, borrowers typically seek to lock in lower rates of interest to save on interest rate costs over time. When rates are rising interest rate risk is higher for lenders since they have foregone profits from issuing fixed-rate mortgage loans that could be earning higher interest over time in a variable rate scenario.