Buying a home is complicated enough without wondering if your mortgage rate is going to change at some point in the future and with it, your monthly payment.
But what if risking that change was really worth your while?
That would sound crazy to anyone who’s experienced or even simply followed the recent mortgage crisis, with people’s mortgage payments jumping two- or three-fold thanks to the skyrocketing rates on their exotic mortgage loans.
But lately, traditional adjustable rate mortgages – those that carry a fixed rate for an initial one, three, five or seven years and whose rate resets annually thereafter – have been making a comeback.
It’s not that homeowners and potential buyers have forgotten the recent mortgage crisis – there are still more than enough foreclosures in many neighborhoods serving as a painful reminder – but the recent interest rate environment has made ARMs appealing once again.
ARM rates, in fact, have historically been significantly lower than traditional 30-year fixed mortgage rates. But in the past few years, that gap was nearly closed or even in some cases reversed (with ARM rates higher than 30-year fixed rates) and for that period of time, most consumers simply went with what made most financial sense, as well as gave them a feeling of security in those very insecure economic times: a mortgage loan whose rate was fixed for 30 years.
Today, however, you could say that things are back to normal. According to Bankrate.com, the average 30-year fixed mortgage loan was at 4.78% (as of April 25, 2011), while that of a 5/1 ARM was 3.32%. For someone who plans to stay in their house for only five years or less, a 5/1 ARM would bring substantial monthly savings.
Hence the recent surge of popularity.
According to a Federal Reserve Bank of New York Study, ARMs comprised up to 70% of all mortgages in 1995. By 2010, that number was down to 10%. But ARMs are making a comeback in 2011. Financial giant Bank of America says it has doubled its ARM business. The Mortgage Bankers Association has also reported an uptick in ARM activity so far in 2011.
Usually, ARMs work best for homeowners who plan on moving within 10 years, or who at least plan on refinancing before their ARM rate adjusts. Homebuyers who use jumbo loans are drawn to ARMs, too, as they keep monthly payments lower for the first few years of the mortgage loan.
Adjustable rate mortgages boil down a secure, fixed interest rate from 30 years to a much shorter time frame – usually one to seven years. During that time frame, ARM interest rates are significantly lower than a rate tied to a 30-year fixed-mortgage.
But consumer beware – after that time period expires, the mortgage rate is “reset” – meaning it can rise two or three percentage points, depending on the mortgage market. To protect themselves against a higher reset, homeowners who have ARMs refinance into a fixed rate mortgage just before the ARM rate expires (or they sell the house).
How does an ARM stack up against a fixed mortgage in dollars?
Quicken Loans offers a good example: A $200,000 five-year ARM with a rate of 3.99%, with 1.75 points applied, will produce a $953 monthly payment, while a 30-year fixed mortgage at 4.99%, with the same 1.75 points applied, generates a $1,073 monthly payment.
Over the five-year period, you’d save a total of $7,200 – or $120 per month – by choosing the ARM option over its fixed-rate cousin.
How to Get the Best Deals
The key to finding the best ARM deals today? Simply follow the same rule you heard when you were 15 years old: do your homework. Arm yourself with fresh data on prevailing interest rates and trends (check mortgage rate sites like BankingmyWay.com or Bankrate.com every week, if not every day), and find trustworthy brokers and lenders to help with your final decision.
Kick your ARM campaign into higher gear with these ideas:
– Evaluate your housing wants and needs. Because interest rates are lower for adjustable rate loans, it’s a bit easier to borrow more, although not as easy as it was before the credit crunch. The first rule of home financing is that you don’t want to overextend yourself, but this added bit of leverage can be important to first-time homebuyers who are already stretching the limits of what they can afford.
– Talk with a reputable mortgage broker. Comparing different lenders’ standard variable rates is a good way to determine who’s offering the best rates overall. (Make sure whoever you talk with isn’t set on selling you just an adjustable rate loan, but is willing to discuss and advise on all mortgage options). Don’t be afraid to ask questions, and get full disclosure on lender’s fees (credit check, appraisal, inspection, recording fees, and other processing costs) as well as any prepayment penalties that might apply to your loan.
- Pace yourself. In general, adjustable rate loans work well with buyers who need to keep their monthly payments low for the first one to five years, whether they’re paying off student loans, or plan to tackle major renovations and want to keep some cash in the bank. Adjustable rates are also a good bet for those who expect to move within the next few years. These loans usually come with a low introductory rate for a given period, after which time your interest rates (and therefore payments) can jump significantly. So just be sure to take this into account.
Plan for a “Worst Case” Scenario
While lenders have certainly gone back to the more conservative traditional ARMs in recent years (forget about Options ARMs and the no money down, no-doc loans — many called them “liar loans” of the mid-2000s), that doesn’t mean that ARMs are bullet-proof. Before you take the plunge, simply consider what could happen if interest rates went up to their maximum allowed under contract. Your potential lender should be able to provide you that information. Ask the lender: What’s the most you would have to pay on that loan? Then ask yourself, Is that something you’d be able to afford?
Is It Time to Consider an Adjustable Rate Mortgage? was provided by CreditSesame.com, a free tool that helps people manage their credit, mortgage and debt.