Would You Take An ARM Mortgage In This Rate Environment?

by Kevin on April 29, 2013

If you need to take a mortgage in order to buy a new home, or refinance the one that you have, would you consider an adjustable rate mortgage (ARM), or will you stick with the good, old reliable fixed rate loan?

Most people have an overwhelming preference for fixed-rate mortgages, but there are still a number of people out there who are more than willing to take a chance on an ARM. They reason that they can save some money on the house payment for a few years, and if rates rise they can always sell the house and move on.

Unfortunately, with ARM loans it doesn’t always work out that cleanly. You should favor a fixed rate mortgage as a result.

Passing up the lowest fixed rate mortgages in history

A case can be made for going with an ARM in a high interest rate environment. They certainly made a lot of sense back in the 1980s, when fixed-rate mortgages were well into double digit levels. If rates are that high, you can take an ARM as a way to ride out the situation. And when rates begin to fall you can either refinance, or wait for a downward adjustment in your loan to take place.

But we are not in a high interest rate environment by any stretch of imagination. In fact, we are now experiencing the lowest mortgage rates in recorded history! That should make a 30 year mortgage a no-brainer. You can lock in the lowest rates in history, with virtually zero risk of your interest rate or payment rising for three decades.

Trading certainty for a crap shoot

Let’s compare the certainty of 30 year fixed rate mortgage, with the potential adjustments built into the typical ARM loan. Most ARM loans come with a fixed rate term the beginning of the loan. On a five-year ARM, your rate and payment will be fixed for the first five years of the loan. In the current market, you can save about .75 versus the rate on a fixed rate loan. That’s the good news.

But ARM loans come with “caps”, or predetermined limits on how far the rates can go in any direction. Most ARM loans have something like a 5/2/5 cap provision. Under this arrangement, your rate can rise no more than five percentage points on the first adjustment. If for example, your initial rate during a fixed rate period is 3%, your rate can adjust to as high as 8% at the end of that term.

After the first rate adjustment, the maximum you can move in any direction is two percentage points. However, the lifetime cap – the third number in the 5/2/5 – is also five percentage points. Were you to go all the way to 8% in the first adjustment, you would already be at the highest rate permitted under the loan. At that point you’re able go down – by as much as two percentage points per year – but it will not go up.

But here’s the catch: while the caps limit how high your rate can go in any one year, or over the life of the loan, they don’t work so perfectly when rates are dropping. ARM loans also have a rate floor below which they cannot drop. For many loans, that floor is set at the initial rate. That is to say that if your initial rate was 3%, your rate will never drop below this no matter how low rates go. The rate adjustments then only go up but not down – or at least not down as in below your beginning rate.

Compare those rate- and payment-fluctuations to the certainty of a 30 year fixed-rate loan. Would you trade that certainty for a higher rate after five years?

What if you don’t/can’t sell in five years?

One of the major reasons why anyone would take an ARM loan is that they fully expect that they will sell the home within five years – or before the rate begins to adjust. That would be an excellent strategy if you could guarantee that you will be able to dispose of the property within that time for a reasonable price. If you can’t, the ARM strategy could blow up on you.

The 3% mortgage that you took can turn into an 8% mortgage. The same factors that caused your loan to adjust up to the maximum will also likely have caused interest rates to rise across the board. Translation: you may be stuck in the house with a very high house payment.

An additional complication is that if rates were to rise that high, it would probably put a crimp in the housing market, making it harder to sell your house and maybe even force you to sell at a lower price as a result.

That would be a true nightmare scenario!

The 30 year fixed rate mortgage is the biggest loan bonanza in history!

Let’s take the high road on the mortgage front for moment. If you could borrow a large amount of money that will be locked into a rate of less than 4% for 30 years, would you pass it up? That is exactly what you’d be doing if you took an ARM rather than a 30 year fixed-rate loan.

And if rates drop below what you’re now paying on the 30 year fixed, you can always refinance at the lower rate. If rates rise, you can sit back and do nothing – you’re covered for 30 years!

The same is not true for your mortgage lender. If they extend you a 30 year mortgage at a rate of 3.75%, and interest rates rise to 6.00%, they’ll be stuck carrying the low rate mortgage in a higher interest rate environment. All the risk with a 30 year mortgage is with the lender, not the borrower!

The 30 year fixed rate mortgage is a complete bonanza for the homeowner.

Would you pass that up?

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