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Why Not Prepay ARMs?

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Posted On: 01/02/2013

QUESTION:

You write about the advantages of prepaying fixed-rate mortgages but not the benefits of paying ahead with adjustable rate mortgages. I have prepaid my ARM over time and now enjoy far lower monthly costs because of less principal and lower rates. Why not encourage more people to take this approach?

ANSWER:

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You raise an important point. ARMs can be attractive for some borrowers, and prepaying such loans can be advantageous.

You understand and have taken advantage of ARMs, as rates have largely declined over time. You have also prepaid your loan, which is generally a good thing.

The issue faced by many borrowers is different. The savings rate in the U.S. is less than 4 percent. In many cases, tough economic times make prepayments difficult.

ARMs in general shift the risk of inflation from lenders to consumers. That’s not a problem at this time, but it could be in the future if rates rise and payments go higher.

For instance, as this is written, 30-year fixed-rate financing for well-qualified borrowers is available below 3.5 percent. That’s near the historic low for mortgage rates – but what if rates go higher? The fact is that rates can plainly go up: In 1982, mortgage levels were above 14 percent.

For those with fixed-rate mortgages, rising interest levels are not a financial threat. But for ARM borrowers, higher monthly costs can make ownership difficult if not impossible, especially for households where jobs have been lost or income has declined.

If ARMs seem enticing, then look at FHA, VA and conventional ARMs. Such loan products have rate caps to prevent payment shock and prohibit prepayment penalties.

The catch is that rate “caps” do not mean monthly costs cannot rise, only that they cannot rise above certain limits. If the thought of bigger payments for principal and interest seems unsettling, then stick with a fixed-rate mortgage – it’s a big-ticket hedge against inflation.

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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