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Advantages of an Adjustable Rate Mortgage
Understanding the Terms of an Adjustable Rate Mortgage - the 4 key points
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Advantages of an Adjustable Rate Mortgage
When you have a long-term plan for your home mortgage in place, the hybrid ARM programs that are available can literally save you thousands of dollars on your mortgage. Working with a mortgage banker to plan out your mortgage will put you into a much better position than borrowers who stick to fixed rate mortgages other than the borrower who will never move again.
While many borrowers believe that a conservative approach and a fixed rate is worth more than taking a risk, the proper use of Hybrid ARM programs is what I would call an active conservative approach to getting your mortgage paid off in the least expensive way.
Advantages
The Rate is Fixed for a period of time of your choice
Interest Rates run in Cycles - Take Advantage
Rates and Payments are Lower on Adjustable Rate Mortgages
First, you need to take a look at long-term mortgage rates and understand that those rates move in cycles and that what many advertise as great rates in 2005 are actually much the same rates that were available in 1998 and in 1993.
Since the creation of the mortgage 'industry' some twenty years ago, the mortgage rate dips and rises have come and go more than a few times. With the right kind of planning and the right mortgage banker to work with, you can take advantage of those dips.
Understanding the Terms of an ARM
Every ARM has four main components. Before you sign anything, know and understand these 4 variables of an ARM and how they may affect your mortgage.
- Initial Interest Rate
- Adjustment Interval
- Index
- Margin
The first number indicates how many years the rate is fixed, while the second number indicates how often the interest rate will adjust. For instance, a 3-1 ARM is fixed for 3 years and will adjust every 1 year thereafter.
You can also obtain mortgages that will change just once. This might be a 7-23, where the rate is fixed for the first 7 years and then will adjust just once and be fixed again for the next 23 years.
The longer an ARM is fixed before adjusting, the higher the starting interest rate will be.
Some ARM's also have a third number attached which indicates the maximum your rate may adjust at any one time, for instance a 5-1-2 or a 5-1-5. A 5-1-2 could only adjust 2% on each adjustment while the 5-1-5 could adjust up to 5% on each adjustment.
If interest rates were to rise 5% before the adjustment period began, the difference could create quite a bit of savings since with the 5-1-5 the first adjutment would take on the entire 5% increase while with the 5-1-2 would increase 2% the first year, another 2% the second year and finally catch up to the 5-1-5 in the third year of adjustments.
Index is the second term to ask about when obtaining an ARM mortgage. This is the index that your interest rate will be tied to once the adjustable period begins.
The 3 most common indexes are the Treasury Index, the LIBOR Index and the 11th District Cost of Funds Index or the COFI. All of these indexes are published in the Wall Street Journal.
- The Treasury Index is tied to the treasury rate of the United States and will vary with the increases and decreases made by the Fed.
- The LIBOR index is the London International Overnight Bank Rate and will vary as rates are changed in England and Europe.
- The COFI or the 11th District Cost of Funds rate is the most volatile rate of all the indexes. It will rise quicer that the other inices and will also fall quicker.
Margin is the amount above the index that will determine the interest rate you will pay when the adjustment period begins on your mortgage. E.G. a 5% margin would indicate that your new interest rate would be 5% above the current index rate.
Be sure to understand this feature if you expect to still have the mortgage after it begins to adjust. Different Banks have different margins and a smaller margin may be available for a slightly higher Initial Interest Rate and be in your advantage over the long run.
How much are you saving and what could it cost you?
While the ARM products can save quite a bit of money for a borrower and is certainly one of the most innovative products available in the mortgage industry that truly gives the borrower an advantage over the system, there are undoubtably risks associated with an ARM.
In the right situation, for the right borrower ther is no better product than an ARM. In times of low interest rates, be very careful about what you are doing.
There are more than a few borrowers who just want that "lowest rate" or "lowest payment" that have not looked at the long term consequences of choosing this product. Weigh those risks before choosing an ARM and there will be no surprises for you.
I mention this because there are more than a few mortgage professionals who want to sell you on the idea of an ARM when it isn't in your best interests for the simple fact that they will get another paycheck when you come back to refinance again. I actually had a past boss who based his entire business on this method of making sure borrowers kept coming back.
The chart below shows the payments for a $150,000 mortgage for a 30 year fixed and a 3, 5 and 7 year ARM
Know how much these savings are before making a decision to take an ARM as the savings may not make up for the risk of taking an ARM.
| Loan Term | Rate | Monthly Payment | Savings |
| 30 year fixed rate mortgage | 5.75% | 875.36 | - |
| 3 year ARM | 4.50% | 760.03 | 3 years savings
4,151.88 |
| 5 year ARM | 5.00% | 805.23 | 5 years savings 4,207.80 |
| 7 year ARM | 5.25% | 828.31 | 7 years savings 3,952.20 |
On the positive side, any of these programs will save you about $4,000 that makes absolutely no sense to pay to a bank if you can keep it in your pocket. For the borrower who will either sell their home, refinance to make improvements or pay for college or be switching to a 15 year mortgage this can be a great plan.
On the negative side, let's say that interest rates have gone up 2% so that a 30 year fixed mortgage is now available at 7.75% and a 15 year mortgage is available at 7.25%.
As you can see from the chart below, the new 30 year fixed rate mortgage payment would be $200 more than it is now, effectively using up the entire $4,000 of savings in less than 2 years!!
| Loan Term | Rate | Monthly Payment |
| 30 year fixed rate mortgage | 7.75% | 1,074.62 |
| 15 year fixed rate mortgage | 7.25% | 1,369.29 |
| 15 year fixed rate mortgage | 5.75% | 1,245.62 |
Even switching over to the 15 year mortgage is actually a more costly scenario in this situation.
It would actually be cheaper to simply start making larger payments to pay off the 30 year mortgage in 15 years.
The cost of $123.67 a month is a whopping $22,260.60 over a period of 15 years!
Now, understand that this is only a made up scenario and these are not actual figures since anything could happen to the market. However, average interest rates are in the 7's so this is a very real possibility.
Summary
An adjustable rate mortgage is a very powerful tool for saving money and you should always use anything in your advantage to get the best deal possible for yourself.
However, as with anything powerful, when not used correctly it can be very costly as well.
As always, the very best solution is to get an honest mortgage professional who will truly do the best thing for you. These professionals know that they will make more money off of the good referrals than they will ever make off of getting you to refinance again and again!
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Harry
Smith
email Harry@dailyinterest.com or reach me by phone Office 1-248-548-7655 Cell 1-248-514-9000 |
Drew
Smith
email drew@dailyinterest.com or reach me by phone Office 1-248-548-7655 Cell 1-248-703-7770 |
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