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ARMs may not be as harmful as you think

The shadow of a house key falls over a mortgage application form.

Steve Chiotakis: At the peak of the housing boom, more than a third of American home loan applications were for adjustable rate mortgages. ARMs, for short, have interest rates that adjust over time.

But as the housing market crashed, those ARMs smacked many home owners with higher interest rates and payments. And ARMs fell to less than
1 percent of the market as the crisis set in. They became an option for the very rich or the very brave. Now, with more competitive interest rates, the adjustable rate mortgage is making a comeback.

Marketplace's Jeff Horwich reports.


Jeff Horwich: When your reputation has been trashed as thoroughly as the adjustable rate mortgage, it can be hard to get people to take you seriously again.

So it goes for Jennifer Larsen, a senior loan officer with HomeStreet Bank in Portland, Ore.

Jennifer Larsen: The fear of the product is more persuasive than the math for some customers.

Larsen says even when the numbers on paper show thousands -- sometimes tens of thousands -- of dollars in savings compared with a fixed-rate loan, most people run the other way.

Larsen: People either don't understand how a conventional ARM works, don't want to understand or are just so frightened that they they're either not gonna be able to sell their house or they might lose their job.

Hey, who's not scared of that stuff? And aren't ARMs practically synonymous with that subprime business that caused the housing crisis? Well...

Ed Nelson: Not all ARM products are bad. We can just say that right out front.

Ed Nelson saw his share of bad ones at the nonprofit Minnesota Home Ownership Center: So-called "exploding" ARMs tricked out with deceptive "teaser" rates, pre-payment penalties, interest rates that reset from zero to 14 percent -- all pushed on people who couldn't really afford a house to begin with.

Nelson: Many of those products thankfully are out of the market and hopefully will never return. We can drive a stake through those products and never, ever let them come back.

Most ARM products that survived the slaughter are Dullsville by comparison and thoroughly mainstream. Belying their predatory reputation, many are even backed by the Federal Housing Administration.

Alex Stenback is a mortgage banker who writes the blog "Behind the Mortgage."

Alex Stenback: There are caps in place, protections for the consumer so that the rates don't typically rise more than 1 percent in any one adjustment period, which is normally a year. And over the life of the loan, they can't rise more than, typically, five points.

But an ARM by definition still involves that gamble: The risk that rates will go up. Fresh off the recession, the last thing many of us want is more risk in our lives. So people willing to roll the dice get a pretty steep discount. Right now, the rate on a typical 30-year fixed-rate loan is about 4.8 percent. Not bad. But ARM rates start at 3.8, and go down from there. By historical standards, the gap is huge.

Brian Colonna: We're moving out of my in-laws, it's our first home, so I'm excited.

Brian Colonna is about to close on a house in Warminster, Penn. using a 5/1 ARM. That means his rate is fixed for five years, then adjusts each year after that. For those first five years, his monthly payment will be $300 less than with a fixed-rate loan.

Colonna: We were able to get the payment down to what we can afford right now. This way, we have some money still kept in our savings, and still be able to do things that need to be done to the house.

A calculation for Marketplace Money by iLoan Home Mortgage compares a 30-year-fixed to a 7/1 ARM, at today's rates. A borrower with a $150,000 loan saves almost $10,000 in those first seven years. In a worst-case scenario, it would take nine years of maximum rate increases after that to undo those savings. And most mortgages don't last that long: The average life span of a U.S. home loan is six to seven years.

Brian Colonna in Pennsylvania plans to refinance his in two. But Ed Nelson of the Minnesota Home Ownership Center is worried by such exit plans.

Ed Nelson: Some of my warning bells are going off. The fact that people are being told all the time, "You'll be able to refinance, you'll be able to get yourself out of this product in a year or two." And the more dangerous part is, "Don't worry, you won't be in the house long enough for this to hurt you."

Given the stagnant housing market, Nelson recommends your own personal stress test: If your rate went up as much as possible, as fast as possible, could you still afford it? And can you still sleep soundly at night, knowing your rate might go up? If you can, then perhaps it's worth giving at least a respectful glance to the adjustable rate mortgage.

I'm Jeff Horwich for Marketplace Money.


Chiotakis: Later in the show, a look at the hot real estate market in China.

About the author

Jeff Horwich is the interim host of Marketplace Morning Report and a sometime-Marketplace reporter.

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