When Alan Greenspan said that Adjustable-Rate-Mortgage (ARM) loans were a better choice
than fixed rate loans, people start to pay attention. So if ARM loans could have saved homeowners very significant amounts
of money, why have Fixed-Rate products been the overwhelming favorite? The answer could be in a simple lack of understanding,
experience, or perhaps it is an unjustified fear. Once an understanding is gained of the proper way to make comparisons between
loans that can adjust vs. those that are fixed, as well as the historical data, a homeowner may be much more open to selecting
an ARM loan and reaping the benefits.
There are lots of ARM loans to choose from and the features can vary quite a bit. The time that an ARM will remain fixed before
adjusting and the factors governing the future adjustments, including the maximum amount the rate can change are important
points to consider. The future adjustments are based on an index, so understanding what will cause the index to fluctuate
as well as historical data on the index; both are important to know.
Let’s look at one popular type of ARM…a 5/1. This loan will remain fixed for the first five years but then adjust
every year thereafter. A common misunderstanding that many consumers will have is that they feel they should only consider
the 5/1 ARM if they plan to be in their home for five years or less. They often fail to recognize that the savings made in
the first five years will offset future years of possible higher payments if the rate on the ARM increases. The best way to
illustrate this is to look at a specific example. It is very common for the rate of a 5/1 ARM to be about 1% lower that the
rate on a 30-year fixed loan. Assume the loan amount were $300,000. The 1% savings on the 5/1 ARM would save the borrower
about $200 each month for the first 60 months (5 years). That would net them a hefty savings of $12,000 during that time.
But most borrowers worry about what will happen after the initial period. If the $12,000 savings during the initial five years
were just placed in a piggy bank, there would be enough funds there to draw upon to cover future worst case increases for
the following 2-3 years. This assures the borrower of coming out ahead by selecting the 5/1 ARM for 7-8 years. Compare that
to the average life of a home loan, which is four years (because people will refinance or sell their home) and the odds become
stacked in your favor that the ARM will add Dollars to your bank account.
Back to The Future
They say a picture is worth
a thousand words. The chart below may be worth thousands of dollars. Over the past 200-years, interest rates on the US 10-year Treasury Note have, for the most part, remained fairly tame. The average has been close to 6%, but many
fear the chance of runaway double-digit rates. Rates have remained in the single digits for all except 8 of the 214 years
shown below. The rampant inflation of the late 1970’s had to be reigned in. So rates were pushed higher during the 1980’s..
The result…low inflation and rates over the years leading to the present time. The lesson learned by the Fed was to
use an ounce of prevention instead of a pound of cure. In other words, the Fed acts quickly now to hike rates a little so
that inflation will remain in check, which helps keep rates from running significantly higher. The sky-high rates of the early
1980’s will probably never be seen again.
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I
Am Not A Gambler
Many homeowners say they refuse
to take a gamble on their selection of a mortgage product so they stick with a fixed rate. Well, like it or not, whatever
the choice is, it’s a gamble. Selecting a fixed rate still means they are betting that, during the time they are obligated
to pay the mortgage, the fixed will perform better than the ARM. Either way, they are rolling the dice and making a bet. The
only difference is they will know the result of the fixed payment. The key here is to get the odds to work in your favor.
This is where understanding and guidance from a professional
loan originator can be worth its weight in gold.
Let’s
Get Creative
Another
strategy that can be used for the above mentioned example is to take the $200 monthly savings and use it to reduce the balance
on the mortgage. The pre-payment of principal will have an even greater effect because the borrower is now skipping down the
amortization schedule and paying more principal and less interest on each subsequent payment. After the initial 60 payments
made during the first five years, the borrower would have approximately $17,000 more equity in their home because of the reduced
principal balance. Because the borrower has this extra $17,000 in equity, they would be better off with their 5/1 ARM for
approximately 10 full years. This is true if rates moved higher after the initial five years…even in the worst-case
rising rate scenario. And, it just so happens that the National Association of Realtors states that the average period of
time that people sell their residence is every 10 years.
Another
benefit when using the strategy of reducing the principal balance happens at the time of the initial adjustment. When an ARM
loan adjusts, it essentially becomes a new loan where the payments are based upon the remaining years, the new interest rate
and the remaining balance. Because the remaining balance is significantly lower when the savings are used to reduce principal,
the payment can actually go down even if the interest rate adjusts higher.
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