Why Should I Even Consider an Adjustable-Rate Mortgage?
Because today’s historically low fixed mortgage rates are, well, history.
Oh sure, mortgage rates are still low. But the interest rates on 30-year fixed-rate mortgages are now up in the mid-4s range from the mid-3s range just a few months ago, and are poised to go even higher before the end of this year.
While mortgage interest rates are still near historic lows, a low long-term fixed rate appeals to many borrowers. But, you may be able to save even more with an adjustable-rate mortgage (ARM) right now. An adjustable-rate mortgage offers an initial low introductory rate period (typically the first 1, 3, 5, or 7 years). During the low introductory rate period, you get a lower interest rate than you could with a fixed-rate mortgage. After that initial introductory rate period, the interest rate can go up or down on a regularly scheduled basis, which is typically once every 12 months.
The typical adjustable-rate mortgages include:
- the 1-year adjustable-rate mortgage or 1/1 ARM;
- the hybrid 3/1 ARM;
- the hybrid 5/1 ARM; and
- the hybrid 7/1 ARM.
A 1-year adjustable-rate mortgage is just that ─ a mortgage where the low introductory rate remains fixed for the first 12 months, then changes at the end of that first 12 months and every 12 months thereafter. For the hybrid ARMs, the first number represents the number of years (3, 5, or 7) for the initial introductory rate period, while the second number (1) indicates that the interest rate can change every 12 months starting from the end of the fixed rate period.
All adjustable-rate mortgages have interest rate caps. There is a yearly or periodic cap and a life-time cap as well. For the 1-year ARM, the interest rate can not go up or down more than yearly cap, or 1 percentage point, after the first 12 month period and every 12 months thereafter. In addition, the rate can not go up or down more than the lifetime cap, or 5 percentage points.
For the hybrid ARMs, the caps work a little differently. They typically have what are known as 5/2/5 caps. What this means is that at the first adjustment, the interest rate can go up or down as much as 5 percentage points, then can change by as much as 2 percentage points every year thereafter. However, there is also a lifetime cap of 5 percentage points. This means that if the initial interest rate is 3%, then the highest interest rate on the loan can never be more than 8%.
Now I’m not advocating that everyone should go out and get an adjustable-rate mortgage. They’re not for everyone. But for some people, they make perfect financial sense. For example, homeowners who plan to live in their current home for no more than 4 - 7 years, and for those who plan to stay in their homes and pay off their mortgages early, an adjustable-rate mortgage can be a very useful financial product that can help them save thousands of dollars in mortgage payments.
Now let’s look at a homebuyer who owns a business. He buys a house and takes out a $400,000 mortgage, but plans to sell and buy a larger home sometime between years 4 and 7. The borrower is also considering taking out a 5/1 ARM instead of a 30-year fixed rate mortgage.
Using Freddie Mac’s historical weekly rates as a guide, I’ll use a rate of 3.25% for a 5/1 ARM, and a rate of 4.5% for a 30-year fixed rate mortgage.
Remember, in a typical 5/1 ARM, the interest rate is fixed for the first 5 years.
For the first five years on a 5/1 ARM, the homebuyer's monthly principal and interest payments would be just $1741, and the remaining balance on his mortgage after 5 years would be $357,227.
With a 30-year fixed rate mortgage, however, his monthly payments would be $2027 ─ or $288 more than what he'd pay under the 5/1 ARM. In addition, his mortgage balance at the end of 5 years would be $364,632, or $7,405 more than with the 5/1 ARM. By using a 5/1 ARM instead of a 30-year fixed rate mortgage, his cumulative savings after 5 years would be $24,685.
So, unless you definitely plan to stay in your home and your mortgage over the long term, it might pay to consider an adjustable-rate mortgage instead of a fixed-rate mortgage.
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East Bridgewater, MA 02333
Lew Corcoran, ASP®, IAHSP, IAHSP-CB