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Are ARMs Now the Best Loan Option?

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Posted On: 04/29/2015

QUESTION:

We know that mortgage rates are low today, so doesn’t it make sense to get an adjustable-rate mortgage at this time and lock in ridiculously depressed rates for the next few years?

ANSWER:

As this is written, the latest weekly rates from Freddie Mac show that 30-year fixed rate loans are available at 3.8 percent, while a 5/1 ARM – a loan with a fixed rate for five years and then annual rate changes – is priced at 2.99 percent. In practical terms, if you borrow $150,000, the monthly cost for principal and interest will be $698.94 for the fixed-rate mortgage and $631.60 during the first five years for the ARM.

The difference between the two loans is $67.34, for a total of $4,040.20 over five years. What happens after five years is anyone’s guess; ARM rates could rise or fall. The question is whether the risk of a potential rate increase is worth the savings.

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According to Ellie Mae, in January ARMs represented just 5.1 percent of all loan originations, not evidence of much support for adjustable products. That said, there are three reasons why it might make sense to consider ARMs:

1. The lower monthly cost for principal and interest means that borrowers may be able to qualify more easily or borrow more. Lenders who offer qualified mortgages generally want borrowers to allocate not more than 43 percent of their gross monthly income for recurring debts, so it follows that lower mortgage costs make it easier to qualify for financing.

2. ARMs come in various shapes and sizes. You can get a 1-year ARM or even a 10-year ARM. The idea is that the initial rate is locked in for a set period. The longer the initial fixed term the smaller the discount when compared with a fixed-rate product.

In our example we used a five-year ARM. According to Freddie Mac the typical loan is now refinanced after 6.8 years. This is a figure that moves up and down, but it suggests that someone with a five-year ARM might not have much rate-hike risk because the loan will likely be refinanced or paid off with the sale of the house in the two years after a 5/1 ARM adjusts. Alternatively, if your goal is to get a loan at today’s rates and keep the financing in place for many years then an ARM may not be desirable.

3. In our look at monthly costs we saw that the ARM borrower had clear monthly savings, at least for the first five years of the loan term. However, with a loan that can be prepaid in whole or in part without penalty – and that includes virtually all qualified mortgages originated today – there’s no reason that a borrower cannot not make monthly ARM prepayments (say the $67.34 per month in our example) so that when the mortgage rate does reset there will be less principal outstanding and, thus, less impact if rates should go higher.

As always, mortgage financing should be guided by one core principle: Do what’s in your best interest, and makes you feel most comfortable. For details and specifics, speak with local lenders.

Peter G. Miller is the author of The Common-Sense Mortgage and a veteran real estate columnist. Have a question? Please write to peter@ctwfeatures.com.

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