Are you looking to finance your home without spending an arm and a leg? In the past, the usual wisdom was that you should get a 30-year fixed mortgage because the rate won’t change. It may be time to adjust that thinking.
Going with an adjustable rate mortgage (ARM) could save clients in the right situation a ton of money in the long run. At the same time, we know that there been a lot of misconceptions around ARMs in the past several years.
In order to help sort fact from fiction and talk about the type of client for which an ARM is right, we talked to Dan Brown, a senior director of mortgage banking at Quicken Loans. With that, let’s arm you with some knowledge.
In order to get a real feel of whether an ARM is right for you, first, we need to define what it is and what it isn’t.
How Do ARMs Work?
An ARM does involve a rate that adjusts. What you may not know is that the first part of the term actually involves a fixed rate lower than current market rates for fixed loans. They all have 30-year terms.
When shopping for an ARM, you might hear about a 10/1 ARM or a 10-year ARM. This means that the rate you’re given at the beginning of the loan will stay fixed for 10 years and adjust up or down once per year at the end of the fixed period.
When an ARM adjusts, the new rate is based on an index added to a margin. For Fannie Mae, Freddie Mac and jumbo loans, the determining rate is based on the one-year London Interbank Offered Rate (LIBOR). On the other hand, loans backed by the FHA or VA are based on the one-year Constant Maturity Treasury (CMT). These yields are updated daily.
Since all ARMS are 30-year loans, the balance is reamortized over the remainder of the term each time the rate adjusts up or down.
There are several misconceptions about today’s adjustable rate mortgages. The first one Brown wanted to tackle was a perception left over from the mid-2000s housing bubble.
“Most clients are nervous about the loan because they have the misconceptions based on negative amortization ARMs in 2009 and before,” Brown said.
Negative amortization loans helped some lenders insulate their clients from interest rate changes by allowing them to make a payment in an amount specified in their contract. The problem was, if that payment wasn’t high enough to cover the interest on the loan, this leftover interest was added on to the principal. Instead of paying down the loan, clients would actually owe more.
This puts the client at risk, and most lenders, including Quicken Loans, don’t offer them.
The second misconception is that your rate will go up indefinitely. This simply isn’t the case.
When you choose to go with an ARM, there are caps put in place on how much your rate can adjust upward. Among these, there’s a cap on how much your rate can go up at the time of the initial adjustment and every year after that. Finally, there’s a cap on how high your rate can go over the life of the loan. Even in a worst-case scenario, your rate can’t rise forever.
Now that we’ve gone over what an ARM is and isn’t, let’s go over the benefits.
When an ARM Makes Sense
When you take a 30-year fixed-rate mortgage, you pay a premium for that extra security, but the security may not be as necessary as many of us think.
According to the National Association of REALTORS, the average length of time people stay in one home is 10 years. Depending on market conditions, you may find it makes sense to refinance even sooner than that. In any case, there’s a very good chance that many of us will be out of our home by the time it adjusts.
It’s the savings you maintain over the fixed-rate period that can make an ARM particularly attractive.
Brown provided the following hypothetical example:
- On a $200,000 loan, a hypothetical rate for a 30-year fixed loan might be 4.75%. The payment savings for the fixed period of a 10-year ARM at 3.99% would be $90 per month and $10,800 over the first 10 years.
Of course, the right loan for you depends on your goals and market conditions when you buy or refinance. As rates push higher, the spread between a 30-year fixed loan and a 5- or 10-year ARM tends to widen, making ARMs more attractive relative to higher fixed rates.
An ARM also provides you with a certain amount of financial flexibility. Because your payment is so much lower, you do have the option of putting the money you save toward other things you need. On the other hand, if you have funds available, you could choose to put the money you save on the monthly payment directly toward the principal and pay off your balance faster.
Finally, if at the end of your fixed term, you’re craving security, you may be able to refinance into a fixed term with a smaller loan amount because you’ve already spent 10 years paying down that balance. If you go with a shorter-term, you may be able to get a rate similar to the adjustable ones that are lower than current fixed rates.
Do you think an ARM might be right for you? If so, you can get started today with Rocket Mortgage. If you’d prefer to get started with one of our Home Loan Experts, you can call (800) 785-4788 and we’ll be happy to chat.
If so, subscribe now for tips on home, money, and life delivered straight to your inbox.