ARMs are making a comeback. These loans with lower start rates (for introductory periods of up to a decade) are enjoying renewed popularity. But are you a good candidate for an adjustable-rate mortgage?
ARMs Are Strong
Figures just released by Freddie Mac show that ARMs represented about ten percent of the mortgage marketplace in 2013, a share which is expected to reach 12 percent this year. The reasons for the new interest in ARMs is fairly plain: lower costs up front.
In its 30th Annual Adjustable-Rate Mortgage (ARM) Survey, Freddie Mac says that ARM rates have generally increased during the past year, no surprise given that mortgage rates in general have gone up from the historic lows seen in late 2012 and early 2013. Importantly, the difference bewteen ARM start rates and fixed-rates can be substantial.
"For a $250,000 loan," says Freddie Mac, "the monthly principal and interest payment on a 5/1 hybrid would be about $194 less than on the 30-year fixed-rate loan over the first five years of the loan." Given a 60-month introductory or start period, the ARM borrower would save roughly $11,640.
ARMs versus Fixed Loans
While this example makes ARMs sound like the obvious financial choice when compared with a fixed-rate loan, it should be said that ARMs are complex financial products. They work for some borrowers but not for others.
Most ARMs today are hybrid loan products. They first have an introductory period (also called a "teaser") with a fixed interest rate and then convert to adjustable rate mortgages with rates that can change at regular intervals. The introductory period can be anywhere from one to ten years, with the most popular being five years.
The Freddie Mac chart below shows several topics borrowers should cover when discussing the various mortgage options available to them.
First, while 15-year and 30-year fixed-rate financing was available from all 106 lenders surveyed, the same is not true with specific ARM products. For instance, 71 percent of the lenders surveyed offered 5/1 ARMs -- ARMs with a fixed rate for five years. However, only 20 percent offered ARM with an introductory period of years. These numbers suggest that borrowers should shop around and consider a variety of hybrid ARM options.
Second, the 15-year mortgage has a substantially lower rate than 30-year financing, 3.56 percent versus 4.51 percent at this writing. The lower rate is certainly enticing, borrowers should be aware that because the mortgage term is shorter, the required principal and interest payments are substantial higher. For instance, a $150,000 mortgage at 4.51 percent over 30 years requires monthly payments of $761 for principal and interest. The same loan for 15 years at 3.56 percent creates a monthly payment of $1,077.
While the interest rate for the 15-year product is lower in this case, and while it produces real interest savings, it may be that borrowers will not qualify for the higher required payments or feel comfortable with larger a monthly obligation. You have to look carefully at your finances and preferences to see which option is the most appealing.
ARMs and Start Periods
Third, interest rates really dip with short introductory periods. The mortgage rate for a 1-year ARM is substantially lower than a 5-year, 7-year or 10-year ARM. However, once the start period ends, rates -- and payments -- may go up or down. The possibility of higher monthly costs should be seen as real, and borrowers should consider how such higher payments might impact monthly budgets.
Fourth, as start periods get longer, interest rates actually get into fixed-rate territory. Are you better off with a longer-term start period or a fixed-rate loan, perhaps for 15 or 20 years? This is not just a question of rates and monthly payments; the reality is that most loans are not held to term because owners move or refinance well before 30 years or even 15 years. In other words, if you have a 10/1 ARM -- and move after eight years -- you will effectively paid a discounted mortgage rate for the effective life of the loan, eight years in this case.
As always, look carefully at both fixed-rate and adjustable options, shop around and choose the loan which best meets your needs and preferences.