As the housing bubble was inflating in the mid 2000?s one of the often-abused mortgage types was the ARM or adjustable rate mortgage. As a result of that abuse ARM’s have gotten somewhat of a bad reputation among consumers. But when used correctly ARM’s can be excellent mortgages. That is why government agencies like the FHA and VA still offer ARM’s, as do quasi-government agencies Fannie Mae and Freddie Mac.
The appeal of ARM mortgages is that the rates can be significantly lower than 30 year fixed mortgages. For instance, in recent weeks rates on 5 year ARMs were in the mid threes. That is nearly 1.5% lower than the average 30 year fixed interest rate in the same time period.
When is an ARM appropriate? The most obvious answer is ARMs are great for people who plan to sell their homes in the next 10 years or less. It is not uncommon for someone to know they plan to sell their home in the next 3-5 years for various reasons like growing families, or wanting to downsize, or knowing a job related move is pending.
Here is an example:
Fictional Borrower, Lisa, has a $200k mortgage at a 6% interest rate and would like to take advantage of the historically low interest rates we are seeing lately by refinancing. Lisa plans to sell her home in the next 5 years or so. If she were to finance at 5% on a 30 year fixed mortgage her principal and interest payments (excluding escrow) should drop about $126 per month — from about $1200/month to about $1074/month. However if she were to refinance to a 5 year ARM at about 3.5% her principal and interest payments (excluding escrow) would drop about $211 per month — from about $1200/month to about $899/month. In her case the 5-year ARM rather than a 30-year fixed would add up to more than $1000 per year in additional savings and would be a better fit based on her plans to sell the home in about 5 years.
The main risk of getting an ARM is that if a borrower ends up owning the property after the ARM begins to reset the rates are likely to rise. So it is useful for borrowers to have some level of confidence that they are going to sell the home before choosing and ARM. In many cases ARMs can only increase 1% per year after the resetting begins, so there is some ramp up time, but in cases where borrowers don’t plan to sell the home it is usually wiser and less costly in the long run to just refinance into a 30 year fixed rate instead of an ARM. On the flip side, in cases where borrowers plan to sell in the next 5-10 years it doesn’t make a lot of sense to pay an extra premium for a 30 year fixed rate.
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