In the event the end of the term is approaching, it could be time to start considering refinancing, or even home shopping. For those who bought a home with an adjustable rate mortgage (ARM) thinking you’d sell the house prior to the ARM adjusted, you’re not the only one. Many people buy homes with an ARM because they intend to relocate or upgrade to a larger home in the near- to medium-term. But when plans change and you simply decide to stay, you must understand what will occur to your ARM – and what you’re able to do about it. Let’s take a look.
ARM vs. fixed rates
ARMs help your budget because rates on ARMs are lower than they are for fixed loans. For example, today’s rates for a mortgage loan on a $300,000 home purchase with 20 percent down are 2.75 % to get a 5/1 ARM versus 3.5 % for a 30-year fixed. In this scenario, the monthly 5/1 ARM payment ($980) is $98 less expensive than the 30-year fixed payment ($1,078).
This ARM vs. fixed savings is significant no matter what your home purchase price is, and if you’re in fact only keeping the home (or the loan) short term, it may be of great benefit.
How to choose
The best way to decide if you go with an ARM or a fixed loan would be to peg your loan term as closely as you can to your expected time horizon in the home or the loan. Here are some options to consider:
If you’re purchasing a home with plans to relocate and sell the home within five years, a 5/1 ARM might be a wise decision. If you’re going to move within 10 years, a 10/1 ARM would be a great option. There is also 3/1 and 7/1 ARMs.
If you plan to repay the loan off within 5 years and keep the home, a 5/1 ARM would also be a good option.
If you’re planning to relocate but want to keep the home, a fixed loan would be a wise decision.
How your ARM will adjust
If you get an ARM and plans change so that you will need to keep the home (or the loan) longer than you intended, your payment will adjust at the conclusion of the ARM’s fixed period.
An ARM is a 30-year loan with a rate that’s fixed for the initial time period of the ARM. For example, the quoted rate on a 5/1 ARM is going to be fixed for that initial five-year period. With the remaining 25 years, it will adjust to a base rate (called a margin) in addition to the current level of a certain index the loan is tied to.
A common margin for a 5/1 ARM on a conforming loan up to $417,000 is 2.25 %, and a common index for these particular loans is the one-year LIBOR which is 1.25 percent as of this week.
If your 5/1 ARM adjusted today, it would adjust to a rate of 3.5 percent, which is the 2.25-percent margin together with 1.25-percent LIBOR index level as of now, and it will adjust once annually every year following the initial five-year fixed period. The margin will always be 2.25 percent, however the LIBOR index changes in real time, and will be higher if economic conditions improve, or lower if economic conditions worsen in the future.
And finally, it’s not just the interest rate that adjusts, it’s also your payment. While in the initial five-year period, the payment is calculated while using the initial rate and a 30-year amortization. After the initial period, the payment is calculated using the margin plus index rate and a 25-year amortization.
Using our scenario above, this means your payment would adjust from $980 to $1,063.
What to do if your ARM is almost out of time
You could argue that a payment adjustment similar to this would be tolerable if perhaps you were keeping the home (or the loan), but this example is simply the first adjustment, and it will adjust on a yearly basis after the initial adjustment, so it’s a great deal of risk to take on.
The alternative is to refinance into a new loan, and the same rule would apply for deciding what loan to refinance into: do your best to peg the new loan term to your expected time horizon in the home (or loan) from this point forward.
Rates have been steadily low over the past five years since the economy continues to be slowly recovering from the economic crisis. If this type of recovery and economic growth continues, rates have more risk of rising.
As such, if you opted for a new 5/1 ARM today, it would be safest to believe that your particular rate and payment would adjust up in another five years. Should this be too much risk for you personally, the best choice is to take a slightly higher rate and payment now using a 30-year fixed, which gives you the security of knowing your rate and payment cannot change.
Other important details of ARMs
Keep in mind that the payments above don’t include property insurance and property taxes, which would be the same whether you chose an ARM or a fixed loan. You can run your own fixed vs. ARM scenarios, and the results will show you homeowners insurance and property taxes.
Another point to remember is that ARMs shouldn’t be utilized to be eligible for more home than you really can afford. This has been perhaps the most common scenario prior to the economic crisis, when lenders were permitted to qualify borrowers using the lower ARM payment. Now lenders must use the highest-case payment that could occur after the adjustment.
As a final note, if your loan amount is up to $417,000, a 5/1 ARM will get you the best savings when compared with a 30-year fixed. For those who have a jumbo loan above $417,000, you can also get strong savings having a 7/1 ARM relative to a 30-year fixed, so ask your lender to provide both options.
Nick & Cindy Davis work with several lenders here in the Tampa Bay area. We can recommend someone who will show you which scenario would be best suited for your your home purchase. Please feel free to give us a call at 813-300-7116, or simply click here and we will be back in touch shortly.