My cousin, Todd worked for a leading architect firm in the state as a young executive. When he was offered the job he was promised significant annual increment including many other benefits that other companies did not offer. After a year, he decided to buy a home. At the advice of his friends, he opted for the adjustable rate home loan because he believed that with the yearly increments he probably could afford to cope with a high interest rate if the rates increase in the future. Plus, the 7 year ARM rate allowed him to enjoy a relatively lower fixed interest rate for the first seven years of the life of the loan. As the current market rate at the time of his mortgage application was at an all-time low he went for it. By the time he’d get to the adjustment period his salary would have increased and he would have no problem paying off a high interest rate.

However, after more than six years of service the world was hit with the worst economic downturn in history and the firm was shut down due to losses of great heights. Todd was one of many employees of the firm that went out of work. Expenses were dear and there were debts to pay. However, with no income he had no means to pay off his debts including his mortgages. He was also worried because the adjustable period of his 7 year ARM rate was almost due and the current market rate at the time was high. He moved in with his sister who was thankfully spared of the unemployment ramifications of the recession. He could not sell his home because the real estate value dropped significantly so he still had to pay off his mortgage. When the adjustable period came, the interest rate on his home went sky high. Todd knew he could no longer afford his mortgage and with the addition of many other delinquent debts and almost a year of unemployment he had to file for bankruptcy.

Like Todd, many people delve into the hybrid adjustable rate home loan without being fully aware of the risks it carries. Of course, it probably would not have been any different if Todd had opted for interest only mortgages where he would only be required to pay off only the interests in the first few years but the long term outcome would probably still be the same. He would end up having to pay a higher monthly amount later on in the life of his loan. Even if Todd had not lost his job he would probably still suffer financially because of the substantial increase in the monthly mortgage payment that he would have to pay. As he was not an observer of the interest rates of the property market, he probably would have no way of knowing whether the rates would work in his favor later on. He learned the hard way that when the initial seven-year fixed interest rate was at its lowest, there would be no other way for it to go but up.

I remember that prior to signing up for adjustable rate mortgages Todd did a rough calculation of the long term implications of an ARM. He imagined every possible scenario including a very high increase of interest rate in his calculations and was confident that he would still be able to afford the loan up to the end of his loan life. But Todd was an architect and not a financial expert. An ARM calculation method may be quite complicated as it relies on various types of indices. New rates could be introduced every year and there was probably no way for Todd to predict the outcome. Of course there were annual and lifetime caps that may limit how much the payment may increase but the financial impact may be felt even if the figure is still well below the designated caps. So in the long run, the loan balance may continue to stay high because rising rates may be adjusted into the monthly payments rather quickly.

Compared to a fixed rate mortgage, an ARM may carry more risks. However, it may not be all that bad. Todd learned that the biggest mistake he commited was that he did not understand the long term benefits and risks of the ARM before signing up for it. He also acknowledged that he probably got over-confident with the promises of his employers. Basically anyone contemplating an ARM may want to be completely aware of the full extent of this particular type of home loan before delving into it.

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Category: Finances
Keywords: 7 year arm rate, interest only mortgages, adjustable rate mortgages