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Better ARM

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Posted On: 12/20/2017

Question: Fixed-rate mortgages are generally in the 4 percent range at this time, but a 5/1 adjustable-rate mortgage (ARM) is available at 3.15 percent. Doesn’t it make sense to take the ARM?

Answer: There’s no doubt the ARM has the lower rate but it’s a “start” rate and not the forever rate that you get with fixed-rate financing. In the case of a 5/1 ARM, there’s a fixed rate for the first five years of the loan term. In year six and beyond, the mortgage rate can change up or down each year.

There are two questions here: First, how much can the monthly cost of the ARM rise? Second, will you own the loan longer enough to be concerned?

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A loan officer might say you’re looking at a 5/1 ARM with a 3.15 percent start rate and 5/1/5 caps. What this means in plain language is that after the five-year start period ends, the interest rate on the loan can rise as much as 5 percentage points with the initial change, up to 1 percent annually and no more than 5 percent over the life of the loan.

In year six and beyond, the mortgage rate can change up or down each year based on an index such as 1-year Treasury securities or the 11th District Cost of Funds plus a margin such as 2.25 percent. While the margin is the same throughout the loan term, the index can go up or down. It is extremely unlikely the initial interest change will be anywhere near 5 percent, but if the mortgage contract allows it then you have to say that it’s possible. The highest rate for our model loan is 8.15 percent – the 3.15 percent start rate plus 5 percent.

Since October 1, 2016 virtually all ARMs in the U.S. now state that the lowest possible ARM rate is the margin, even if the interest rate turns negative and goes below zero.

For ARM details take a look at the Loan Estimate form (LE) the lender is required to provide. The “projected payments” area on the first page will illustrate the range of monthly costs for principal and interest. On the bottom of page two, in the “Adjustable Payment (AP) Table” you can see the maximum possible monthly cost.

As to that second question, will you own the loan long enough to be concerned, that’s a very real consideration. There isn’t much upside risk with a 5/1 ARM if you refinance or move in the same time frame as most people, but what if you stay longer? Will you have the finances to pay the monthly cost for principal and interest if there’s a stiff rate increase?

Peter G. Miller is author of "The Common-Sense Mortgage," (Kindle 2016). Have a question? Please write to peter@ctwfeatures.com.

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