Adjustable-Rate Mortgages Not as Crazy as They Sound

ADVERTISEMENT

Adjustable-rate mortgages have been blackballed throughout the subprime mortgage crisis. Yet, ARMs are a valid option as a mortgage instrument for homebuyers who do their math properly.

Provided you can afford the home you want to buy, it's in your best interest to choose the type of mortgage that will save you the most money.

Fixed-rate mortgages have accounted for the lion's share of mortgage applications over time, but their popularity has increased significantly in the last year. In 2005, ARMs accounted for almost a third of all mortgage originations, according to historical data from Freddie Mac (FRE). Their share of the market dropped to just 12% in May, the most recent month for which data is available. That's the lowest it's been since 2001.

Consumers' decreasing interest in ARMs is probably related to the risk that owning one means you could be stuck with skyrocketing rates and plummeting home values, the way many homeowners are in places such as California and Florida.

But as the gap widens between the interest rates offered on the two types of mortgage instruments, it may be worth considering an ARM, depending on your situation.

At the start of the year, the average interest rate offered for a 5/1 ARM was less than a quarter percentage point below that offered for a 30-year FRM. (A 5/1 ARM is a hybrid ARM in which the interest rate is fixed for the first five years, followed by rate adjustments every subsequent year.) That difference has almost doubled as of last week's mortgage rate survey, which could have a significant impact on the amount of your monthly payment.

You can use the online calculator from BankingMyWay.com to help sort out how the different rates would affect your monthly payments.

In addition to FRMs and ARMs, the calculator offers the ability to calculate payments on an interest-only ARM (as opposed to the more common fully amortizing ARM). However, the interest-only option should only be considered in specific (and, these days, rare) situations, particularly where home values are rising rapidly.

To use the calculator, you'll need to know the amount and term of your loan, as well as the interest rates offered and details about the rate resets on the ARM.

Say you want to buy a $300,000 home with a $240,000 mortgage. You have the choice between a 30-year FRM at 6.63% and a 5/1 ARM at 6.16% with a 13% rate cap, meaning that your interest rate can't ever exceed 13%. You expect the rate on the ARM to increase by a quarter of a percentage point each year.

Based on those numbers, you would face monthly principal and interest payments of $1,537.54 for the FRM, while you'd pay $1,463.70 for the ARM -- a savings of $886.08 per year, or $4,430.40 over the first five years of the loan.

What's more, the initial savings from the lower rates on the ARM will cover the first few years of rate hikes, until your rate gets high enough that you would have been smarter to go with a FRM in the first place. The calculator calls this date the break-even point, which is really the length of time you can live in your home and have the ARM be the right choice as a mortgage instrument.

In this case, if you live in the home for more than 11 years and nine months, you'd save more with a FRM. But this time frame is based entirely on the expected yearly rate hike of 0.25%.

In most cases, ARMs have a periodic adjustment cap in addition to a lifetime cap. The periodic cap limits the yearly rate hike to a set percentage, usually in the ballpark of 2%. If we change that expected rate increase amount in the calculator, you'll see that you can now only own your home for six years and four months before an FRM would have been the smarter move.

There are many factors to consider before choosing one mortgage instrument over another. (For a more detailed discussion of the pros and cons of ARMs, read here.) But if you crunch the numbers properly, you can make the decision that is right for you.

 

Show Comments

Back to Top