Be frank with ARM and I-O customers: you reap benefits in the long run

The lending industry has observed a strange phenomenon in recent months: Adjustable Rate and Interest-Only mortgages are becoming more popular, not less, as rates remain historically low. The percentage of borrowers opting for ARMs nationally doubled between last summer and this summer. Thirty five percent of borrowers chose ARMs in the second quarter, the Mortgage Bankers Association (MBA) reported.

"They should be doing just the opposite," Richard DeKaser, Chief Economist at National City Bank, told the Cleveland Plain Dealer. Rates are expected to continue to rise and people will have missed their chance to lock in a low, fixed rate.

"When rates are around six percent, ARMs should not be popular," Steve Roth, mortgage product manager at Third Federal Savings in Cleveland, also told the paper.

The allure of bigger, more expensive houses and, some say more importantly, the psychology of what that first payment is going to be, are attracting people to ARMs in record numbers. Four out of 10 homebuyers nationally are expected to pick an adjustable rate by next summer, according to the MBA. Roth described it as "a trend we see across all kinds of consumer products, such as cars. [Borrowers] shop by monthly payment, not necessarily the total price of the car or home loan."

How do you take advantage of the popularity of these programs -while ensuring that your borrowers aren't in for a shock in a few years when their payments nearly double?

First, be up front about the details. Federal and state laws require you to provide, and borrowers to sign, pieces of paper with disclosures and examples of payments under adjustable rates. But be frank, and explain it to your customer while looking him or her in the eye. Tell them that after a certain number of years their payment could go up drastically.

Explain that if they put away what they're saving off the first few years' monthly payment, they'll be in great shape to make the higher payments or to refinance down the road. Tell them property values go up, making higher LTV refinanced loans likely if they choose to go that route, but that not even property values are guaranteed to rise. Finally, tell them if they plan on staying in the home until their kindergartener graduates from high school, an ARM and especially an Interest-Only loan might not be for them.

The reward of being seen as an honest broker, with their interests at heart, is an investment in future business. From your borrowers, if they do need to refinance in a few years, and from referrals. Don't cash that equity in for the immediate gratification of a commission on an ARM or I-O to a borrower who likely can't afford it.

It can't be stressed enough to a borrower considering an I-O loan that they need to bank some of the savings. Explain that money market funds are better than Certificates of Deposit for what could end up being emergency reserves, because they're more liquid. Tell them that with mortgage interest being tax deductible, they should see a tax adviser about possibly re-doing their W-4 forms to allow for less withholdings. Tell them that if that turns out to be a viable option for them, to use this additional money in each paycheck to save for the future.

Finally, explain that a 5-year Interest Only loan really becomes a 25-year mortgage after five years, and tell them what they would pay if they got a 25-year mortgage for the amount they want to borrow now. Explain that that's what they're facing in five years - only with possibly higher rates than are prevailing now. If they plan to sell or refinance at that time, this might be a great way to get into a bigger house for less of a monthly payment.

But if this "sticker shock" dissuades someone who really can't afford it from opting for an I-O loan, you've given them good advice - and a reason to trust you and give you referrals and repeat business.