“Is there any way to benefit from the lower rates on adjustable-rate mortgages (ARMs) without risking payment increases I can’t afford if rates increase sharply?”

With interest rates on ARMs still attractively low but widely expected to rise, I hear this question often.

Despite what you may hear to the contrary, you do not get payment certainty with the flexible-payment ARM, also called “1-Month-Option Arm,” “12 MAT Pay Option ARM,” “Pick a Payment Loan,” “1-Month MTA,” “Cash Flow Option Loan,” and “Pay-Option ARM.” This loan offers conditional payment certainty. Payments won’t increase by more than 7.5 percent a year, provided that interest rates don’t increase too much.

How much is too much? That depends mainly on how low the initial payment is and how large a markup (“margin”) the lender charges you. In an analysis I did last year, I assumed a rate increase of .1 percent a month for 33 months, or 3.3 percentage points in total. This is very far from being a “worst case.” The payment increases that resulted ranged from 31.6 percent in month 61 to 139.6 percent in month 36. Detailed results are on my Web site.

The only way to create absolute payment certainty on an ARM is by making the term uncertain. This is an “accordion loan”: the borrower knows exactly what his payment will be through the life of the loan, but he doesn’t know how long he will have to pay. If rates go up, he pays for a longer period, and if they go down he pays off more quickly. At various times, a few small depositories have offered accordion ARMs, but they have never attracted much business.

The reason is that the accordion loan won’t work if the initial term on the ARM is 30 years because that doesn’t leave enough room for a term extension. Forty years is the practical limit on the term, and an extension from 30 to 40 years offsets only a small increase in the interest rate early in the life of the loan.

If the 30-year ARM rate is 6 percent, for example, extending the term to 40 years (with no change in payment) will offset an immediate rate increase only to 6.7 percent. Since other ARMs allow rate increases of 5 percent or more, a maximum increase of .7 percent is unacceptable to lenders.

To be workable, the initial term on an accordion loan must not exceed 15 years. A term extension from 15 to 40 years would offset an immediate rate increase from 6 percent to 9.93 percent. If the increase was delayed for three years, it could be as high as 11.65 percent. Lenders find this acceptable, which is why the accordion loans that have been offered have had initial terms of 12-15 years. But this makes the payment substantially higher than it would be at 30 years, which limits acceptability to borrowers.

To make the accordion mortgage more affordable, the payment could be graduated as on a graduated-payment mortgage (GPM). On the most popular GPM, for example, the payment increases by 7.5 percent a year for five years before leveling off. The same principle could be applied to the accordion loan. Then lenders would have the rate protection provided by the short initial term, and borrowers would have a more affordable initial payment.

To my knowledge, no lender has ever offered this instrument, which seems ideally suited to the current market environment. I modeled it years ago, when market conditions were similar, then mothballed it until now. I called it the “no-surprise ARM” (NSA) because borrowers knew exactly what the payment would be throughout the life of the loan; they just did not know how long they would have to pay.

I recently compared an NSA with an initial term of 15 years and a maximum of 40 to other ARMs available in the market today, when both have the same initial payments. In a rising rate environment, the preset payment increases on the NSA were smaller than those on other ARMs. While the payments had to be made for 40 years, the balances on the NSA after 10 years were lower.

In a stable rate environment, the NSA had the same rising payments, compared to relatively stable payments on other ARMs. However, the NSA paid off after 15 years rather than 30.

The NSA is for borrowers who want the lower ARM rates, are comfortable with preset rising payments, and prefer to gamble on how long they pay rather than on how much they pay.

I will provide the model to any lender on request.

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.


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