Rate Increases and Wrecked Budgets

Sometimes ARMs appeal to the wrong types of borrowers. During periods of high 30-year fixed interest rates, ARMs permit borrowers to obtain larger loans than they otherwise could. A lower qualifying interest rate when combined with higher qualifying ratios (a feature of some ARMs) attracts marginal borrowers. Because they're struggling from the beginning, unexpected payment increases (called "payment shock") push these types of borrowers into financial distress.

2You could possibly refinance, but that could cost you several thousand dollars—a loss that you would not have incurred had you selected the ARM. Of course, the ARM borrower could also refinance into that new lower rate.

Indeed, in reaction to the recent uptick in ARM defaults, many lenders have decided to qualify ARM borrowers at the fully indexed rate—rather than the teaser rate. Even stricter, some lenders now qualify ARM borrowers at the maximum possible ARM contract rate.

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