Adjustable Rate Mortgages – Why Leave Money on the Table?
Is it the right mortgage for you?
Since the beginning of the financial crisis that struck about 10 years ago, I have only sold adjustable rate mortgages (ARMs) to 2 people. Myself, and a client who is an accountant. Every other person has chosen to go with a 30 or 15 year fixed rate loan. Now, if you can afford the payment on a 15-year loan, I would not necessarily discourage you, but that is a conversation for another time. However, many homeowners should ask themselves why they consistently pay a higher rate for a 30 year fixed rate loan when, on average, nearly all homeowners will either sell or refinance within 7 years or less. For these borrowers, they might have saved a half percent per year for the length of their loan had they opted for the lower, shorter-term rate.
What are Adjustable Rate Mortgages?
An ARM is generally amortized over the same 30 years as a fixed rate loan. However, the rate is only fixed for a period of 3, 5, 7, or 10 years. After that, it adjusts every so often (could be every 6 months, 1 year, or even 5 years) and the payment adjusts so that the loan will go to zero within that same total 30-year time frame. The new rate at each change will be the sum of the margin and the index it is tied to. The margin is an amount that serves as the floor rate (lowest possible) and is usually 2.25%-2.75%. The index is a published variable rate like the 1-year t-bill or the LIBOR (currently about 2%).
The rate generally cannot go up by more than 5% from the initial rate, which sounds like a lot, but in most programs, it cannot go up by more than 2% in a given year. As mentioned, there is also a floor, whereby the rate cannot go lower than the margin. Mathematically, these terms work out to an ARM frequently being guaranteed to be cheaper than a 30 year fixed even after a good number of years have passed with a higher rate on the tail end.
Holding on to an ARM for a long time in a high-interest rate environment could, of course, eventually lead to you being on the wrong side of things, but statistically very few borrowers will ever be in that camp. During all those years, there will likely be multiple opportunities to either extend with a new ARM or switch to a product that makes more sense for you at that stage in your life.
What does this mean for you?
To sum up, if you can see yourself having a time horizon on your loan of less than 12 or 13 years, a 7 year ARM or even a 10 year ARM could save you money for many years and take you far along in the overall life of your home financing, freeing up money each money to invest or spend on other priorities.
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