The gain may outweigh the risk in this move to pay off your mortgage early.
Most homeowners have a love-hate relationship with their mortgage. They love the idea of owning a home but hate spending decades paying it off to finally own it.If you feel the same way, you might want to consider taking a bold step to pay off your mortgage faster – purchasing an adjustable rate mortgage (ARM).
Though not as popular as the much more common fixed-rate mortgage (FRM), an ARM might be the right choice if you’re willing to trade in the long-term stability of steady house payments for the riskier, short-term gain of lower interest rates for a specified period of time.
“I think adjustable-rate mortgages are a financial tool that, if used in the most proper way, will provide people a chance to maximize their money and provide a greater return,” says Nicole Rueth, a producing branch manager for Fairway Independent Mortgage in Golden, Colorado. “But if that tool is not understood and used appropriately, it could bite you.”
Interested in learning more? Then read on for answers to four key questions about ARMs and why they might be worth the risk for some homebuyers.
Question #1: How does an ARM differ from a FRM?
As the names suggests, ARMs and FRMs differ in how interest rates are applied over the term of the loan. According to the U.S. Department of Housing and Urban Development (HUD), an ARM is subject to changes in interest rates, and its monthly payments could increase or decrease at intervals determined by the lender.
For example, a borrower can agree to a 5-year ARM – also known as a 5/1-year ARM – which has a fixed interest rate for the first five years. But every year after that, the rate could change annually, according to the Federal Reserve Board’s “Consumer Handbook on Adjustable-Rate Mortgages.”
On the other hand, an FRM never sees a change in its interest rate, unless you refinance out of it into another loan. So, if you purchase a 30-year FRM with a 5 percent interest rate, your rate and monthly mortgage payment remain the same for entire 360-month span of the loan.
But here’s the real hook of an ARM: Interest rates for adjustable mortgages generally start out lower than those of their FRM counterparts. The Federal Reserve Board reports lenders are prone to offer lower interest rates on ARMs, in part, to attract borrowers to the loans.
Notes the Federal Reserve Board: “At first, this makes the ARM easier on your pocketbook than would be a fixed-rate mortgage for the same loan amount. Moreover, your ARM could be less expensive over a long period than a fixed-rate mortgage – for example, if interest rates remain steady or move lower.”
Harris Rosenblatt, a senior mortgage banker with Eagle Bank of Potomac, Maryland says borrowers seem to have an aversion to ARMs when they actually might be a better choice than FRMs in plenty of cases.
“People take fixed-rate mortgages out of fear, but the 5-year [ARM] is a better product over time,” says Rosenblatt .
Rosenblatt says he bases his pro-ARM stance on his personal observations of the performance of ARMS. He says ARMs mortgages typically don’t see drastic rises in interest rates over time, meaning they potentially can be more cost-effective than FRMs during the lifetime of mortgages.
So how do different types of mortgages stack up in terms of interest rates? According to Freddie Mac, the government mortgage loan entity, as of September 25, 2014, the average interest rate for a 30-year FRM was 4.2 percent (and 3.36 percent for a 15-year FRM). By comparison, the average interest rate for a 5/1-year ARM was 3.08 percent and 2.43 percent for a 1-year ARM.
Question #2: How can an ARM help a homeowner pay off debt?
An ARM is a “prudent investment,” because it has the potential to enable borrowers to have more cash in hand earlier in the loan, says Rosenblatt. Because interest rates for ARMs are likely to be lower than interest rates for FRMs at the start, Rosenblatt says borrowers save money with adjustable-rate loans.
“[Purchasing an ARM] will allow you to allocate more resources to pay your debts,” Rosenblatt says.
Rosenblatt offers this comparison between a 5/1-year ARM and a 30-year FRM on a home loan of $417,000: If the ARM in this case has 2.875 percent interest rate, the monthly payment is $1,730 for the first 60 months of the loan. The FRM, with a 4.25 percent interest rate, has a monthly payment of $2,051.
Over the first five years of the loan, you would save $13,860 by going with an ARM instead of an FRM. You could then apply those savings to higher-yielding investments, says Rueth.
“The reason you get an ARM is so that you can get the lower interest rate today and optimize your cash flow,” Rueth says. “What I try to do is educate the borrower to use it as an investment vehicle.”
But the danger remains that the interest rate on an ARM will rise after the first fixed-rate period ends, Rosenblatt acknowledges. For that reason, Rosenblatt says, people worry they might suffer from a bad case of sticker shock if their interest rates and monthly payments increase by a substantial amount.
“Your understanding of the product will allow you to have less stress about it,” Rosenblatt says.
But if the interest rates do begin to rise, caps on how high they can go provide a measure of comfort to borrowers who might worry about ARMs over the long term, he explains.
Question #3: What are the risks and drawbacks of an ARM?
The length of time that an ARM’s interest rate stays fixed – whether 1, 5, 7, or 10 years, for example – might be likened to a honeymoon period. As long as the interest rate is low and stable, the homeowner certainly can feel good about his or her relationship with the mortgage.
But once the ARM reaches the point where the interest rate could go up or down, panic might set in for the borrower. In the worst-case scenario, according to Rosenblatt, the interest rate that was at 2.875 percent for 5 years could swell to 4.875 percent in its first year of adjustment and go up even more every year thereafter until it hits a cap.
Although there are caps that determine how much an ARM’s interest rate can elevate (2 percent annually and 5 percent over the lifetime of the loan), any rise in the interest rate will increase the homeowner’s monthly payment.
Rosenblatt says understanding what factors might contribute to an ARM’s rise in interest rate could help borrowers better determine whether an adjustable loan is right for them. He points to the London Interbank Offered Rate (LIBOR) as one of the most common interest rate indexes to make adjustments to ARMs.
“Knowing how the LIBOR works will help people have less fear about what will happen at the end of an ARM term,” Rosenblatt says.
The Federal Reserve Board reports that the LIBOR is among a handful of indexes that lenders might use to determine the rise and fall of interest rates on ARMs.
As a suggestion, the Federal Reserve Board says you should ask your lender what index will be used for your ARM, how it has fluctuated in the past, and where the index is published so that you might track its progress, either online or in major newspapers.
Question #4: Who should consider an ARM and who should not?
Rosenblatt, who serves the Washington, D.C., area, estimates that about one-fourth of the loans he services are ARMs. The main reason for such a high percentage of adjustable loans, he says, is that people who work in the governmental or political areas tend to be more transient.
“A mortgage in my market lasts only 4.1 years on average,” Rosenblatt says. “People sell their homes or refinance into other products.”
So, no matter where you live, if you know that you’re going to be staying in a home for a set period of time – let’s say 5 years – a 5/1-year ARM might make sense. You could experience the benefit of having a lower interest rate and monthly payments for five years before you sell or refinance the property.
According to John Friedman, an advice-only financial planner based in San Francisco, an ARM might be ideal for people who have contract jobs, military personnel who are used to moving, or those who have a definite time for how long they want to stay in a particular home.
Friedman says, however, “A lot of times, people think they’re going to move and they don’t. Yes, people with ARMs are paying a lower interest rate than anyone else is paying, but if they are going to live somewhere long-term, I wouldn’t suggest they get an ARM.”
People who might be uneasy about the potential of fluctuating interest rates might also want to steer clear of ARMS. But Rueth points out that to qualify for ARMs, borrowers are vetted to determine whether they have the financial means to potentially handle higher interest rates should they adjust that way.
In other words, if you purchase an ARM with a 3 percent interest rate, you need to be able to afford payments at a 5 percent interest rate – just in case your rate ever reached the highest cap figure of the interest rate, Rueth says.
Keep in mind that the scenario of your interest rates ever reaching its highest cap figure or going up dramatically seems pretty unlikely if recent trends of the indexes are any indication, according to Friedman. Still, ARMs are not for everyone.
“They are for people who can stomach the fluctuation of the market in the future,” Friedman says. “They are not for people who are risk adverse.”