Perhaps one of the greatest obstacles you might have in discussing ARM loans with borrowers is all the ARM loan myths that persist today.
In our last post, we discussed ARM loans and how their structure can be beneficial to borrowers. Today, we want to discuss the most prevalent ARM loan myths and how you can help borrowers overcome them. We’ll also cover questions you should ensure your borrowers can answer and examples you can provide to help them understand if an ARM loan is right for them.
Dispelling ARM Loan Myths
Despite the potential financial benefits, your borrower may still have doubts, as there is just something innately comforting about a long-term fixed interest rate. Let’s examine some of the common misconceptions of ARM loans and how you can address your borrower’s concerns.
Myth: ARM Loan Rates Are Unpredictable and Will Only Rise
Truth: At the time of rate adjustment, borrowers could see their rates go down. Future rate changes are based upon the rate environment at the time of the adjustment. The loan’s interest rate is always set against a standard market Index (i.e. Treasury Bill, Prime) plus an established margin.
Borrower Advice: Share some historical data on the index with your borrower to get them more comfortable with the nature of rate cycles. While you cannot guarantee their rate won’t increase, you can demonstrate there is opportunity for it to move downward just the same.
Myth: ARM Loans Will Lead to Significant Payment Increases i.e. “Payment Shock”
Truth: Payments on ARM loans are recalculated at the time of a scheduled rate change. The payment is recalculated based upon the new interest rate, outstanding principal balance, and remaining term. Pre-determined CAPS (provide protections against steep increases) limit how much the rate can adjust each period. They can help a borrower better predict potential payment changes.
In some cases, interest rates can decrease in favorable environments thereby leading to a decrease in payment amount.
Borrower Advice: Have a chart ready to go that can show different rate adjustments side by side. Show a maximum increase, mid-range, and decrease example.
Learn more about ARM Loans in our free webinar course
Myth: ARM Loans Are Only for Short-Term Buyers
Truth: The truth in this myth is that short-term buyers most always would benefit from an ARM product due to the lower interest rates offered for the period they intend to own the home (think 3-7 years).
Even for those homeowners who retain their residence, the average life of a mortgage loan in today’s market remains in the 5- to 7-year range, having increased from recent historical lows, driven by various refinance motivators like lower rates, cash-out, home improvement, college expenses, etc.
Borrower Advice: For homeowners who intend to stay longer, the discussion should shift to monetary savings and realistic loan term expectations. We’ll address some questions around this topic in the “Questions” section.
Myth: ARM Loans Are Subject to Pre-Payment Penalties
Truth: Borrowers tend to believe that by taking advantage of the lower initial rate offerings of an ARM they are subjecting themselves to early payment penalties. Regulations imposed post-recession place strict restrictions against the assessment of pre-payment penalties.
Borrower Advice: Address this misconception early on and point out loan terms that state whether there are pre-payment penalties.
Myth: ARM Loans Will Lead to Negative Amortization
Truth: The recession exposed numerous loan products that had been sold to consumers as Pay Option ARMS. These loans offered borrowers flexible payment options, frequently not even satisfying accruing interest. Any shortfall of interest in these payments was added to the existing loan balance.
During periods of appreciating home values, borrowers were less averse to these risks. In a depreciating environment, however, many borrowers were left “underwater” with loan balances in excess of their home’s value.
Current regulations, again, generally prohibit loans with potential negative amortization.
Borrow Advice: Demonstrate that your borrower’s loan payments will adjust with each scheduled rate change to maintain the original amortization period of the loan. New payments will be calculated based upon the new rate, current outstanding principal balance and remaining amortization period of the loan.
Questions to Focus on with Your Borrowers
As your borrowers are considering an ARM loan, ask them these questions to help them make the right decision for their purchase and finances:
- How long do you anticipate living in this home?
- Will your income increase enough to cover a higher monthly payment if/when your monthly payment increases?
- Can you put enough money aside to manage any large jump in rate increase if your rate rises to the cap during your first adjustment?
- Are you ok with the uncertainty of just how much your monthly payment could increase?
Do remind your customers that just because several of these questions deal with increased payments doesn’t guarantee that their rate will increase. Just let them know it’s best to be prepared for an increased rate rather than be surprised at the time of their first adjustment.
Run the Numbers
One of the best ways you can help your borrowers choose a fixed rate or ARM loan is to show them how the two stack up with different scenarios. Here are some comparisons to consider:
- Payment and Interest savings over the period prior to first rate adjustment
- Increased principal benefit and home equity position
- Break-even point: how much of an increase in rate would negate the short-term financial benefits
Have these comparisons ready to go so you can pull them out to help dispel these ARM loan myths with your borrowers.
Being able to explain the benefits and dispel the ARM loan myths is an increasingly important skill to have as mortgage rates continue to slowly tick up. You’ll be able to provide one more product confidently as well as build more trust between you and your borrowers.