The ARM Alternative
When you’re buying a home, it’s natural to want to reduce your stress level and eliminate as much uncertainty as possible. It’s a big reason why many mortgage borrowers opt for a rate that’s fixed in order to nix any notion of interest variability. But that could be shortsighted and costing you money, say the experts, who recommend trying an adjustable-rate mortgage (ARM) on for size, despite their lack of popularity.
Consider that ARMs accounted for nearly 40 percent of all mortgages in 2005, per the Federal Reserve Bank of New York; but by 2015, they represented only around 5 percent, according to Ellie Mae.
The good news is that ARMs work pretty much like they always have: the usual term is 30 years, with a low initial fixed rate provided in years 1 to 10 depending on the product. After this fixed-rate period expires, the interest rate will adjust annually for the remainder of your loan, according to an index (often the 1-year LIBOR or 1-year Constant Maturity Treasury), plus a margin (typically around 2.25 percent) that’s added to the index rate. As of this writing, that would equate to a rate of a little more than 4 percent, which would reset again every 12 months. Your adjustable rate will also have initial, interim and lifetime caps that limit how high rates can go.
Why pursue a loan where the rate is unpredictable and risky after the initial fixed-rate period expires? Because you can save a lot of dollars in those initial fixed-rate years compared to a conventional fixed-rate mortgage.
“The rates on ARMs today are often at least 50 basis points lower than the 30-year fixed rate, which means you probably can claim an ARM in the mid three-percent range with no points,” says Steven Maizes, vice president of mortgage lending for Guaranteed Rate in Los Angeles.
And that can add up to some serious savings. Hypothetical case in point: if you borrowed $200,000, your monthly principal plus interest payment in each of the first five years on a 5/1 30-year term ARM (with the first five years providing a fixed rate of 3.5 percent) would be $898.09, versus $954.83 monthly for a 30-year fixed-rate mortgage set at 4.0 percent. You’d also pay $4,905.35 less in interest over that five-year period with an ARM.
That’s all well and good, you say, but what if your variable rate goes sky high after year five? How can you sleep at night?
Perhaps you’ll be sleeping in another home before that time, says Keith Furer, senior vice president of GuardHill Financial in New York City.
“Actuarial tables have shown that most homeowners won’t have their mortgage for more than five to seven years. Most will either refinance or sell within that time period,” Furer says.
Even if you stay put, your adjustable rate may not be as scary as you think; tracking the 1-year LIBOR over the last five years, the rate has ranged from as low as 0.53 percent to as high as 1.82 percent.
That’s not to say an ARM is ideal for everyone. The best prospects are folks who plan to move before the fixed-rate period ends, including first-time purchasers and “younger buyers who are growing their careers, income and families” who may move up to a bigger and better home in a few years, Furer says.
“Other good candidates are those who can absorb a higher payment, if it becomes necessary – someone who has more income than needed to qualify for the loan, a good history of saving money, uses credit sparingly or a combination of these,” says Casey Fleming, self-published author of “The Loan Guide” (2014). “Someone on a fixed income that’s not likely to rise, who barely qualifies income-wise or who carries big balances on their credit cards should probably avoid ARMs.”
Gene F. Thompson, president of Houston-based InterLinc Mortgage Services, says most lenders offer ARM products.
“Fully understand the product and how the rate adjusts before committing yourself,” says Thompson, who recommends consulting closely with an experienced mortgage professional on your options.
Additionally, be cautious about an ARM with too short of a fixed interest period, such as one-year, “especially if you are unsure about your future plans,” Furer says. “Also, consider paying points in the transaction (1 point equals 1 percent of the loan amount), which could significantly lower your monthly interest payments.”
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