Lately I have been hearing a lot of commercials that go something like this:
“Have you been thinking about buying or refinancing a home? If so, there has never been a better time to do so! Rates are at an all-time low and so are home prices! You can get a rate as low as 3.05%, fixed for the first 5 years! Call us today!”
A rate of 3.05% sounds tempting, doesn’t it? There is more to it than what it may seem at first, though, and before you jump and make that call, let’s look at some important terms and numbers.
TERMS
Adjustable Rate Mortgage, or ARM, is what is being advertised here. As the name implies, the interest rate changes according to market conditions.
Initial Interest Rate: The stated interest rate that the loan starts out with – in this case 3.05%
Fixed or Adjustment Period: The time period in which your rate cannot increase. In this case the 3.05% interest rate has an adjustment period of 5 years.
Yearly Adjustment Cap: This is the maximum your interest rate can increase annually.
Interest Rate Cap: The maximum your interest rate can increase to over the life of the loan.
3/1, 5/1, 7/1: With an ARM you will see two numbers – the first number represents the adjustment period, so 3, 5 and 7 years, and the second number represents how often the interest rate can increase after that, in most cases it is annually.
NUMBERS
If you run the numbers for an ARM it might look good at first. Let’s take a look at a scenario:
· $165,000 mortgage
· 30 year fixed rate 4.49%[1]
· 5/1 ARM with an initial interest rate of 3.05%, a yearly adjustment cap of 2% and lifetime cap of 5% (which could take the rate as high as 8.05%)[2]
The payment under the fixed rate would be $835.05 while the ARM would be $700.10 (both are principal and interest only, so they do not include taxes and insurance). That is a big difference! With the ARM you save $135 a month, $1620 a year, or $8000 over the first 5 years.
But then the adjustment period ends. Under the terms of this ARM your rate can increase as high as 5.05% as soon as the fifth year ends, but let’s say it only increases 1% per year until it hits the cap, 8.05%, in year ten. Here is how your payment changes:
· Year Six: Interest rate 4.05%, payment $779.08
· Year Seven: Interest rate 5.05%, payment $859.87
· Year Eight: Interest rate 6.05%, payment $942.00
· Year Nine: Interest rate 7.05%, payment $1025.04
· Year Ten: Interest rate 8.05%, payment $1108.59
On year ten you are now paying $273 more than you would be paying on the fixed rate mortgage. Under a 30-year fixed rate mortgage you would pay a total of $300,618, while under the ARM you would pay back $364,639.
Of course, some assumptions are made above that may not actually happen. Maybe the rate will only go up .25%, or won’t increase at all, or may drop in year eight, or any number of other scenarios could happen. You need to look at the worst case scenario, though, and see if you are prepared for that. In fact, the worst case scenario (increase 2% per year until it hits the cap) would do this to your payment:
· Year Six: Interest rate 5.05%, payment $862.63
· Year Seven: Interest rate 7.05%, payment $1036.85
· Year Eight: Interest rate 8.05%, payment $1126.88
Your total payoff is now $375,818.
There are arguments for ARMs, of course, the most common ones being:
· I plan to move after a few years
· I need a lower payment to get into a home – my salary will increase before the payments do
· I can just refinance to a fixed rate if rates go up
All of these are valid points, but have some problems as well.
What happens if you don’t end up moving? Maybe you thought your job would take you elsewhere, but it doesn’t. Or even if you do move, what if you can’t sell your home? Can you afford two mortgage payments? Even if you find renters, what if rent doesn’t cover the full mortgage, or what if they move out and you can’t find new renters, etc. Of course, these things can all happen to someone with a fixed-rate mortgage, but you can’t assume that just because you currently think you are going to move in a few years that you are 100% guaranteed to move or that you will be able to sell it.
As far as needing a lower payment, what happens if your salary doesn’t increase as you thought it would and you can’t afford to pay $1126 a month? That’s a big increase from the original $700 payment. If this is the scenario, you should purchase a home with a lower mortgage with payments you can actually afford if they increase (or better yet, get a home with a lower mortgage and get a fixed rate with payments you can afford).
Finally, as far as refinancing if rates go up, you could do that, but rates have gone up. Instead of 4.49% for a fixed-rate mortgage the rate might be 6.49%, which would increase your payment to about $1041. Also, what if you can’t refinance? Perhaps lending standards are more stringent, or your employment has changed, or you have some credit problems and you can’t refinance anymore at the new rate?
ARMs are becoming more popular – in fact, an article on CNN Money[3] indicates that the number of people financing with an ARM has increased 75% since last year, but ARMs are laden with problems that you need to look at before you jump in.
As always, we welcome your comments and thoughts on our blog at http://MUFinancialTip.blogspot.com.
Ryan H. Law, M.S., AFC
Department of Personal Financial Planning
Office for Financial Success Director
University of Missouri Center on Economic Education Director
239E Stanley Hall
University of Missouri
Columbia, MO 65211
573.882.9211 (office)
573.884.8389 (fax)
[1] The average 30 year rate on 6/2/11, as indicated on http://www.bankrate.com/
2 Rate is the average 5/1 rate on 6/2/11, as indicated on http://www.bankrate.com, and the yearly adjustment and lifetime cap are from a company that is doing a lot of ARM advertising.
3 http://money.cnn.com/2011/06/02/real_estate/ARM_adjustable_rate_mortgage_tips.moneymag/index.htm?iid=HP_River
[1] The average 30 year rate on 6/2/11, as indicated on http://www.bankrate.com/
[2] Rate is the average 5/1 rate on 6/2/11, as indicated on http://www.bankrate.com, and the yearly adjustment and lifetime cap are from a company that is doing a lot of ARM advertising.
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