Why Homebuyers Should Take a Second Look at Adjustable Rate Mortgages

While there are many different types of mortgage products available to meet the needs of anyone buying or refinancing a home, there is one in particular that is surrounded by misinformation, and a lot of confusion: the Adjustable Rate Mortgage or ARM.

ARMs haven’t been very popular in recent years mostly because they were the mortgage product of choice used by unscrupulous lenders that contributed to the housing market crash in 2008. Today, merely suggesting this product as a viable mortgage option makes lenders feel like the villain.

However, much has changed since 2008: there are more protections in place for borrowers, including updated qualifying criteria, and caps on the variable rate. Furthermore, there are plenty of scenarios where the ARM may be a beneficial option to consider. While a traditional fixed-rate may still be where you end up, let’s explore some potential reasons why considering an ARM could be right for you.

First, it’s important to understand how ARMs work. Let’s take a look at an example: a 5/5 ARM.

• The first number, 5, is the number of years where your rate will actually be fixed.

• The second number, 5, is how often the rate adjusts once the fixed-rate portion of your loan is over. A 5/5 ARM would be adjusted based on the market just once every 5 years.

• Let’s say after meeting with your trusted mortgage loan officer, you discover this 5/5 ARM has 2/2/5 caps. As mentioned previously, after 2008 caps were put in place to protect borrowers. In this example 2% would be the limit that the rate can adjust upward the first time that the payment adjusts. Our second 2 also stands for 2%, but this applies to subsequent adjustments.

• Finally, 5% is the lifetime cap. Regardless of market conditions, the interest rate for this mortgage cannot go up more than 5% for as long as you have the loan.

• Reason 1: Based on how they’re built, most ARMs feature a lower initial interest rate compared to a traditional 30-year fixed-rate mortgage. This means your monthly principal and interest payment will also be lower during the initial term of your ARM loan. The key words here are initial interest rate. While the rate does not change during the initial fixed rate period, it will change after that, making this a limited time benefit.

• Reason 2: If you expect to live in the home you’re purchasing for less than five years, a 30-year fixed-rate mortgage is likely more expensive. If you select an ARM with an initial fixed period that matches or exceeds your expected ownership timeline, you’ll benefit from the lower rate compared to the traditional 30-year fixed-rate, and can avoid having to pay a higher rate down the road if you refinance or sell the home before the end of the initial fixed rate period. You might be surprised to also learn that the average stay in a home these days is hovering at about eight years, which means many are staying just a few years, and if they’re savvy homebuyers—that lower initial fixed rate hasn’t even adjusted before they’re ready to sell.

• Reason 3: Monthly interest payments are calculated on the unpaid loan balance. Larger loans therefore accrue more annual interest than smaller loans. ARMs that have a lower initial rate period compared to fixed-rate mortgages can save homeowners money by providing them with years of lower interest payments for higher priced homes.
  
  For example, a $100,000 loan at 5.25% will cost about $5,250 in annual interest while a $400,000 loan at the same rate will cost around $21,000 in annual interest. If the homeowner instead opted for an ARM where the initial rate dropped to 4%, they would save $1,250 in annual interest on the smaller loan amount and about $5,000 on the larger one. Over the span of five years that equates to $6,000 or $25,000, respectively. Paying the closing costs (typically 1-3% of the loan amount) before the rate adjustment period could easily be justified given those savings.

• Reason 4: Most ARMs feature a 30-year repayment period (term) just like a traditional 30-year fixed-rate mortgage. Some lenders have recently begun offering programs that increase that term to 40 years for certain ARM products. A longer repayment period can make monthly payments more manageable, and can also help when it comes to getting approved for a loan.

• Reason 5: If you expect rates will decline over the next several years compared to where they are today, then it may be worth considering an ARM. You can take advantage of the lower interest rate now, and refinance into a low fixed rate when they go down a few years later.

The bottom line is that while ARMs come with the risk of an unknown future market rate, they also have key advantages that an experienced and knowledgeable loan officer can help you consider in relation to your goals and unique situation.

Contact our Mortgage Consultant, Gary Talbot today to discuss if an ARM is right for you.

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