When an Adjustable Rate Home Loan is Right for You
It may be hip to do things unconventionally, but that notion doesn't quite apply when you're choosing a mortgage -- especially when we're talking about an adjustable rate versus a fixed rate. With adjustable rate mortgages making up only 5.5 percent of the loans closed in February 2018, according to mortgage data firm EllieMae, getting an ARM might just mean that you’re more of a real estate hipster than someone who has carefully considered their options.
But we're not jumping to conclusions yet. ARMs aren't for everyone, but that doesn't mean they're not for you. If you're very self-aware and know what you need to do to complement your financial picture, it could be the perfect instrument to help you achieve your goals.
So, when is an adjustable rate home loan right for you? Let's talk about what ARMs are, first.
A Quick Brush-Up on ARMs
Aside from being those things that help your hands stay attached to your shoulders, ARMs are the bad boy loans of the mortgage world. They’re scary for many people because the “a” means adjustable -- and there’s no joke about it, your rates will adjust. But, when you’re applying for an ARM, you have the option to choose an ARM that won’t flex for a while. In fact, there are ARMs currently available to home buyers with initial fixed rates as long as 10 years.
Unlike a fixed rate mortgage, ARMs are priced based on one of several indexes. The primary index is the London Inter-Bank Offered Rate (LIBOR). The long history, predictability, and influence of multiple international member banks make it an ideal global benchmark for establishing consumer loan rates.
That being said, when you secure an ARM, you’ll be told how the initial rate is calculated and the different kinds of interest rate caps on your particular offer. These are vital bits of information, so pay attention:
- Rate calculation. Likely, this will be expressed in very vague terms, like “LIBOR + 1%.” Find out what that means in terms of real money, however, before you sign the document. Is that 4.3 percent? Is it 500 percent? Ask if it isn’t clearly defined on the application and then get it in writing.
- Initial adjustment cap. Your mortgage rate will adjust. That’s the nature of it. But how much it can change matters and will differ between lenders, so make sure you’re on top of this. Your initial adjustment will take place at the end of the “introductory period,” again, anywhere from one year to ten years, depending on the instrument. Often, this cap can be as high as five percent, which is no laughing matter when you have a $250k mortgage.
- Subsequent adjustment caps. How often your mortgage rate can adjust is built right into the name of the product. Did you sign up for a 5/1? That’s a five year fixed rate with adjustments every year thereafter. How about a 3/6? That means you'll have a fixed rate for three years, with an adjustment every six months. Fortunately, there’s a cap on this, too, and typically it’s about two percent per adjustment period.
- Lifetime adjustment cap. This is the saving grace of your ARM. The lifetime adjustment cap is just what it sounds like: how much the rate can rise as long as you have the mortgage. When you’re evaluating these mortgages, make sure to ask your lender about the lifetime cap and have them calculate your payment at that maximum interest rate. If you can afford the mortgage when it's fully adjusted, you’re gold. You don’t want to be surprised by a payment that’s suddenly far outside of your comfort zone. This is one contributing element that led to the destruction of the real estate market in 2008.
How to Win With an ARM
Now that we’ve gotten the technical pieces out of the way, here’s the thing: you can totally rock an ARM and save a ton of money if you do it right.
Today, the rate for a 30 year fixed rate mortgage is 4.625 percent. The rate for a 5/1 ARM is 4.125 and the 7/1 is 4.250. That doesn’t seem like much of a difference, but let’s put the numbers on the paper.
The first chart here is showing what the base payment and interest would be if you borrowed the amount in the header column at the rate on the side. You can already see there’s a significant difference between the 30 year fixed and the 5/1 ARM. It may not seem glaring, but consider that’s a monthly payment:
As you can see, all three of these loans are basically identical through the end of year five. They all have a locked in rate, so the principal and interest figures are based on exactly the same thing. Nothing changes on those ARMs yet.
Now, let’s go to the next chart, where you'll see how an ARM can actually save you a lot of money over time.
After five years, you’ve saved $2,640 on interest alone by choosing the 5/1 ARM over a 30 year fixed on a $150k loan -- and $5,280 if you borrowed $300k with the same loans. Provided you sold or refinanced that home before the last payment at the initial rate, you’ve saved a substantial amount of money by choosing the ARM.
Is an ARM for everyone? No, absolutely not. Some ARMs have such poor terms we wouldn't recommend them for anyone, in fact. But, a standard 5/1 or 7/1 is a product that gives a person with a long term plan a little break on their mortgage payment and an opportunity to save a bit of cash in the meantime.
ARMs and Points to Ponder
It cannot be reiterated often enough that you absolutely have to pay attention to an ARM to make it work well for you. Too many people haven’t, and that’s how adjustable rate mortgages have gotten such a bad rap. A 30-year fixed home loan will let you cruise on autopilot as long as you want, but not the ARM. The ARM can be somewhat like a sneaky financial viper waiting to bite you on the eye.
If you do opt for an ARM, stay aware of when your ARM will flex. Start planning to refinance or sell about six months before that date, in case there are any issues you have to iron out ahead of time. Then, you're free to make it rain with the money you’re saving over a fixed rate mortgage! (As it turns out, you don’t have to be a hipster to make an unpopular mortgage product work for you -- you just have to be a really good financial planner.)
Have More ARM Questions?
ARMs can be confusing and you definitely don’t want to agree to one until you fully understand what your terms are going to be. But that’s why we’re here, ready and waiting for your questions all day and all night. It’s a killer on the social life, but hey, we were just going to sit around the house reading our own blog articles from Home.Loans anyway. So give us a call!