Should lenders apply higher scrutiny when processing applications for ARMs?

Bankrate recently called attention to a rise in the number of adjustable rate mortgages (ARMs) being taken out by American borrowers, which may be attributed to rising interest rates on traditional 30-year fixed-rate mortgages.

The news source cited a recent survey from Freddie Mac, which found that ARMs accounted for about 10 percent of all home-purchase mortgages issued in 2013. Frank Nothaft, vice president and chief economist at Freddie Mac, has said that he believes ARMs will continue to become more popular with borrowers throughout 2014.

Jordan Roth, senior branch manager for GFI Mortgage Bankers, told Bankrate that ARMs can be particularly appealing to borrowers seeking jumbo loans, as there is "a tremendous savings opportunity with an adjustable-rate mortgage," if the terms of the loan are aligned with the borrower's financial situation and planning.

Multiple factors can affect borrowers' ability to realize savings with an ARM, most notably how long they intend to own the home being purchased. Buyers who expect to sell their property within a few years may be able to get a better deal with an ARM. It may also be relevant to consider whether the borrower may be able to refinance before the fixed rate ends.

However, with this type of mortgage, it is important for lenders to be clear about the maximum payment amount that would be affordable for the borrower. If a thorough credit risk assessment isn't performed and the borrower is stretched too thin, the performance of the loan could suffer significantly if interest rates rise in the future.

Bankrate noted that many homeowners who used the Home Affordable Modification Program will soon see their mortgages the interest rates on their mortgages rise, because rates set under the program are only fixed for five years. Citing a report from the Special Inspector General for the Troubled Asset Relief Program, Bankrate reported that interest rates on more than 30,000 mortgages modified in 2009 will increase this year. Next year, the number of homeowners facing an increase will be almost ten times larger.

Alys Cohen, an attorney with the National Consumer Law Center, said borrowers who stand to be affected by this issue will need to determine whether they can afford to make the higher payments and, if necessary, seek further modification on their mortgages. To avoid this type of situation, lenders should always perform credit risk assessments when processing mortgage applications.

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