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Why No Adjustable Loan?

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Posted On: 09/10/2014

Question: We’re buying a home with 10 percent down and would like to get a five-year ARM. Our lender says we easily qualify for a fixed-rate mortgage but will not offer an adjustable-rate loan unless we put down 20 percent. What gives?

Answer: Follow the money.

In rough terms, mortgage rates at this time look like this: 30-year fixed-rate loans at this writing are priced at 4.33 percent while 5/1 ARMs – loans that have a fixed-rate for five years and then adjust annually – have a start rate of 3.23 percent, according to the Mortgage Bankers Association.

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Let’s say you want to borrow $150,000. The monthly cost for principal and interest with the fixed-rate loan will be $745 per month, while the 5/1 ARM will set you back $651. That’s a monthly difference of $94, or $1,128 per year. Over five years the difference amounts to $5,640.

What happens with the ARM after five years is anyone’s guess. The rate can rise or fall. This means there’s additional risk for the borrower in the form of higher costs. There’s also less risk for the lender because the mortgage rate is not fixed, so if inflation hits the lender will get a larger return.

In their self-interest lenders should prefer ARMs because such loans protect them against what’s called “interest-rate risk.”

However, you may not be working with a “lender” in the sense of a company that wants to keep the loan. Instead you may be working with a company that will make the loan and then sell it immediately after closing. It doesn’t really care what happens in five years because long before then the mortgage will be owned by an investor. What it cares about is maximizing the market value of an asset – the loan it’s making to you and then selling. This lender has apparently concluded that its best option is to sell fixed-rate loans into the “secondary market,” the electronic arena where loans are bought and sold.

The real question is: What’s good for you? For instance, at this writing there are lenders offering FHA ARMs at 3.5 percent with 3.5 percent down. However, with FHA financing you generally have to pay a 1.75-percent mortgage insurance premium up front, plus an annual premium of 1.35 percent on the unpaid balance.

Given this background, the best option is to shop around. While your lender may not offer ARMs with 10 percent down other lenders might be very happy to suggest such financing, especially in a marketplace where loan origination volume is falling nationwide. Ask lenders to provide rate quotes at “par” (with zero points for easy comparisons) and 10 percent down for fixed-rate loans, 5/1 ARMs and FHA ARMs. Or, look into something a little more exotic, such as a 15/15 ARM, a loan with a 15-year start rate. If you have the cash also consider 20 percent down, the magic number in lending because it means no mortgage insurance is required.

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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