Would you refinance to get an interest rate below 3%? What if that rate would only last for five years?
Adjustable-rate mortgages conjure images of folks with horrible credit buying homes they can’t really afford, then defaulting on those loans when interest rates climb.
Thanks to the mortgage crisis, we’re all more aware of the risk of ARMs. Those fears, coupled with low interest rates, have kept a lid on ARM demand.
About 6% of borrowers in the current market are opting for ARMs, compared with 20% back in 2007, according to data from Freddie Mac.
But as fixed interest rates rise, the lower rates offered by adjustable-rate home loans grow more tempting.
There are a lot of ARMs out there to choose from, and they’re all named for how long you get to keep the starting interest rate and how often the rate rises after that. For example, a 10/1 ARM adjusts after 10 years and then again every year after that.
What are ARM borrowers getting?
If you have excellent credit (a score of 740+), a 20% downpayment (or 20% home equity), and want a $200,000 loan, what kind of ARM deals are out there? Bankrate.com said your choices last week were a:
- 30-year fixed rate mortgage at 4.4% for a monthly payment of $1,001.52
- 10/1 ARM at 3.52% for a monthly payment of $900.32
- 5/1 ARM at 2.90% for a monthly payment of $832.46
- 3/1 ARM at 2.77% for a monthly payment of $818.60
By opting for the cheapest ARM, the 3/1, you’d save $6,298.80 in the first four years of the loan (compared with the fixed rate loan) and you’d come out ahead if you sold the house or refinanced within seven years and four months, even if the ARM rose to its maximum possible rate, according to Bankrate.com’s ARM vs. fixed-rate loan calculator.
Is an ARM right for you?
Despite their bad reputation, ARMs can be the right loan if you know your income is going to change in the future for reasons like these:
- A spouse will finish school and enter the workforce.
- Kids are starting school and a spouse is going back to work.
- You have a job with regularly scheduled raises based on how long you’ve been on the job.
In those situations, you can get the 3/1 ARM and feel pretty sure you can handle the higher loan payments in three years because you know your family income will rise.
Just be absolutely certain you know how much that ARM payment can go up annually and over the life of the loan. Also, be cautious about interest-only ARMs, because their payments can increase wildly when you start paying back principal, too, compared with a fixed-rate or an ARM that repays the principal from the start of the loan.
There are other times when an ARM makes sense:
- You’re planning to move before the ARM adjusts. Maybe you’re retiring or moving somewhere with lower property taxes once your last kid graduates.
- You want to use principal prepayments to lower your monthly payment. When you send extra payments in for a fixed-rate mortgage, they reduce what you owe and shorten the length of your mortgage, but your monthly payment doesn’t shrink. However, prepaying on an ARM will lower your monthly payment because ARM payments are re-calculated every year. If interest rates stay the same (or fall) and you’ve paid off some principal, your monthly payment will fall.
ARM risk and stress
There’s one category of home owner that really should avoid ARMs no matter how low the rates go: People who can’t sleep at night when they take on financial risk. When you choose an ARM over a fixed-rate mortgage, you’re agreeing to accept lower monthly payments now in exchange for the risk that your monthly payment could rise in the future.
If making that bet is going to leave you miserable and stressed out, go for the more expensive fixed-rate loan. If you’re not wired for risk, the money you save won’t be worth the additional heartburn you’ll give yourself worrying about future payments.
Would you take out an ARM to get the lower interest rate?