It’s inevitable that whenever I mention to a borrower that they might want to consider an FHA 5/1 ARM when either refinancing or even when they are getting their home loan for a purchase, that the question will be raised
“Are they safe?”
Of course this question is rooted in the housing slump and all the news reports about Option ARM’s.
If you look a bit closer you will see that the difference between the ARM’s at the heart of the housing mess and an FHA 5/1 ARM are substantial.
Convention and Interest Only ARM’s
My first encounter with conventional and Interest Only ARM’s was when I was building my first home back in 2004. A friend of mine was building homes and he offered to help me, and a friend build our homes. He said that he had some great contacts for getting mortgages done fast, and since I can’t do my own loan I of course said I would be open to meeting his contact. It was also a nice surprise that they also did Home Loans in Layton where our office is.
I remember having a discussion with my wife’s Uncle whom I hold in high regard with respect to life in general, but especially with financial matters. I told him that I was being offered a loan that started out at 1%!
I had never heard of such a thing, and frankly I had to really think for a while before I felt like I could really get my head around why ANYONE would ever offer such a loan.
The overall theme of the discussion could probably be summarized as “I just don’t get it”.
Musing about Wall Street, where he worked for a good 15-20 years of his Career and about all the different ways that housing was really picking up steam, I still recall at one time one or both of us asking rhetorically “it can’t go on forever like this…can it?”
Two years later, I was still asking the same question and wondering if my understanding of sound fundamental economics might need to be adjusted in the face of some new development. Perhaps housing really could defy economic history and just go up.
Of course we all know what happened within just one more year. Looking back, I made a sound decision in not accepting that ARM, and of all the reasons that it didn’t make sense to me there were a couple that stood out from the crowd.
Here are the factors that separate FHA 5/1 ARM’s from those that caused so much trouble for the housing market.
Prepayment Penalties
Penalties that cost thousands of dollars would cause borrowers to wait until their loan had already become an adjustable rate before they could refinance. New, higher payments often shocked borrowers and led to problems paying either their house or their other bills on time. Late payments made refinancing difficult or impossible. FHA 5/1 ARM’s never have any pre-payment penalties.
Volatile Index
Most ARM’s were based on the LIBOR. I won’t bore you with the details, so I will just say that FHA 5/1 ARM’s are based on the US 1 Year Treasury Bill and not the LIBOR which gives the FHA ARM less volatility.
Caps
With the I/O (interest only) ARM’s of the housing boom rates could often jump up very quickly. Increasing as much as 2 and 3 percent right from the beginning. Alternatively FHA 5/1 ARM’s are capped at 1 percent increase per year based upon the start rate for that year. So if you are starting at say 3.75% on an FHA ARM, after the 5th year passes your rate could not be more than 4.75%. This of course goes on with each successive year after that.
It’s worth noting that the bad ARM’s also had what I call a Parachute. Meaning they rose fast but if rates dropped these loans dropped down slower than they went up. FHA 5/1 ARM’s follow the rates and hold to the 1% cap, meaning they cannot go up or down more than 1% per year. However that also means that if it started at 4.75% and went up to 5.75% in year 7 but then rates went down to 3.75% you could drop down below the 4.75% start rate for the year. Nice!
Streamline option
This in my opinion is one of the strongest benefits of the FHA loan. Put simply, an FHA streamline refinance is like a regular refinance except the lender does not really verify income. They will verify value, employment and credit. The reason it stands out as a benefit is if for some reason you needed to refinance rather than sell, you can do so with less difficulty than a traditional refinance. You can move from an ARM to a Fixed rate loan and vice versa with an FHA loan, even before the 5 year fixed period ended if you wished.
Over all, my general advice to people goes like this. Will you be in the home longer than 7 years? If so, its not likely that an FHA 5/1 ARM makes a lot of sense.
On the other hand, if you will likely be selling within 5-7 years then it might make a lot of sense financially. One client recently dropped from 6.25% all the way down to 4%. Considering thats over a $2,000 per year difference you can see that the savings add up, and if you know what your plans are within that 5-7 year time frame, its worth running the numbers to see if an FHA 5/1 ARM can save you money.
We are local Mortgage Bankers located in Layton Utah, and we like helping people understand their home loans. We write this blog and other articles to share information and answer questions. If you want to get a home loan and live in Northern Utah, give us a call, shoot an email or drop by!
{ 0 comments }
