ARMs revisited as mortgage rates remain very low.
Many homeowners today are under water, that is owing more on their mortgages than what their homes are worth. Others lost their homes when their ARMs reset and the higher rates were beyond their ability to afford there mortgages.
Yet, ARMs are still around and are worth a look if you are in the market for a home. There is still some risk involved, but if you are wise with your borrowing, you can make an ARM work out well for you.
What exactly is an ARM? Unlike fixed interest-rate mortgages, the interest rate on an ARM can adjust. Also known as variable rate mortgages, ARMs will provide you with a fixed interest rate for a specified term. At the end of that term, your rate is subject to resetting. That rate could go up, go down or stay the same.
Typical ARMS are as follows: 3/1, 5/1, 7/1 and 10/1. The first digit represents the number of years your interest rate will stay fixed. The second digit, the one after the slash, represents how often your rate can reset. For example, with a 3/1 mortgage, your interest rate will be the same for the first three years or 36 months. After that, your interest rate will adjust based on changes to LIBOR — the London Interbank Offered Rate or some other index.
The advantage of an ARM versus a traditional fixed rate mortgage is that ARM rates start off lower. For example, if the interest rate on a 30-year fixed rate mortgage is 4 percent, it might be just 2.75 percent for a 5/1 ARM. Essentially, you and the bank are hedging your bets that interest rates will rise once the reset period kicks in. If the rate is nominal, such as .25 percent, then you’ll come out ahead. However, if rates surge to 9 or 10 percent, then you lose the advantage of having a fixed rate for he life of the loan.
An ARM is ideal for homeowners with very good credit who want to purchase a slightly more expensive home than what they might afford with a fixed-rate mortgage. If you plan to live in your home for only a few years, then an ARM will work to your advantage too. That could mean opting for a 7/1 ARM if you plan to stay in your home for no more than five or six years.
How much can you save by choosing an ARM? Using the example previously given, if you borrow $200,000 at 4 percent interest, then your mortgage payment will be $954.83 per month. A 5/1 ARM with a 2.75 percent interest rate will cost you $816.48 per month, for a difference of about $138 per month.
That $138 per month equals $1,656 per year or $8,280 over five years. That’s a lot of money! And, it is money you could probably use for other purposes.
If you plan on staying in your home long term, an ARM can still work for you. What you’ll want to do before the reset period kicks in is to refinance to a new loan, perhaps obtaining a fixed rate mortgage. The risk, of course, is that your financial picture will change and perhaps for the worse. That is what happened to countless homeowners whose loans reset and they lost their jobs. Don’t count on getting a new mortgage if you are out of work, your credit rating has dropped or both.
Once you compare an ARM with a fixed-rate mortgage and understand the risks involved, then you’ll be ready to make your decision. Consult with your financial adviser too especially if your options are not as clear-cut as those mentioned here.
See Also — 4 Timely Tips for First Time Home Buyers