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The New Adjustables

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Posted On: 07/30/2014

Question: We have been looking for a mortgage and our lender, a credit union, recommended a 15/15 adjustable-rate mortgage. This is new to us. What should we know about this loan?

Answer: Interest rates reached historic lows in 2012 and early 2013, and since then rates have increased somewhat. The result has been a greater interest in adjustable-rate mortgages. According to EllieMae, ARMs now represent 7.5 percent of all loan originations, up from 2.1 percent in December 2012.

ARMs come in various formats. You might have 3/1, 5/1, 7/1 or 10/1 options. In each case the first number stands for the “start” period – with a 3/1 ARM you would have a loan where the interest rate is fixed for the first three years of the mortgage term and then adjusts up-or-down annually.

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ARMs generally have start rates that are substantially below regular fixed rates. For instance, as this is written the Mortgage Bankers Association says the rate for a 30-year fixed-rate mortgage is 4.31 percent, while the start rate for a 5/1 ARM – a rate that will not change for five years – is 3.13 percent.

Lenders are willing to make ARMs with a low start rate because they want borrowers to finance with adjustable-rate loans. Why? Borrowers with fixed-rate loans have a shield against inflation; if rates go up it doesn’t matter to the fixed-rate borrower because their rate will never change. If a mortgage has a 4-percent fixed rate and interest levels rise, mortgage investors cannot get better returns for their money because they are stuck with a long-term obligation at a given rate. With an ARM, the rate will rise or fall automatically within annual and lifetime cap limits.

The 15/15 ARM is an effort to find a compromise between the interests of lenders and borrowers. With such financing there’s a 15-year start rate and then a one-time rate readjustment. This largely works well for borrowers because few hold a loan for 15 years; instead the loan is refinanced or the property is sold before the rate changes. On the other side, 15/15 ARMs work well for lenders – or at least better than fixed-rate loans – because the interest level can change if rates go higher over time.

Because the start period with a 15/15 mortgage is so long the discount when compared with a fixed-rate loan will not be great, perhaps 0.25 percent. However, that can be a lot of money. If you have a $200,000 mortgage you’ll save roughly $500 in just the first year.

Looking toward the future it may be that long-term ARMs will become more common. Anyone for 10/10/10 financing or 10/5 mortgages?

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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