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Up in ARMs: A closer look at adjustable loans “Should I get a fixed or adjustable loan?” The answer depends on many factors. Projected length of ownership, cash flow, specific loan terms, economic trends, and asset accumulation strategies all come into play. When Federal Reserve Chairman Alan Greenspan said that adjustable rate mortgage (ARM) loans were a better choice than fixed rate mortgages, the “fixed only” advocates took a second look. Many of them found ARM loans provided greater benefits. There are many ARM loans to choose from. Adjustment periods and caps, along with the index it is tied to are important points to consider when comparing them. The popular 5/1 ARM is a hybrid fixed for the first five years before adjusting every year thereafter. A 5/1 ARM isn’t just for those planning to be in their home for under five years. The savings made in the first five years will offset future years of possible higher payments if the rate on the ARM increases. Example: The rate on a 5/1 ARM is commonly about 1% lower that the rate on a 30-year fixed loan. On a $300,000 loan, the 1% savings would be about $200 a month for the first 60 months (5 yrs). That would net a hefty savings of $12,000 during that time. That’s enough to cover worst-case increases through the seventh or eighth year if all you did was put it the savings in a piggy bank! Better yet… If you used the $200 monthly savings towards principal reduction, the effects are greater. By pre-paying principal, you skip down the amortization schedule and paying more principal and less interest on each subsequent payment. After the initial 60 payments made during the first five years, you’d have approximately $17,000 more equity in your home because of the reduced principal balance. With an extra $17,000 in equity, you’d be better off with a 5/1 ARM for approximately 10 full years. This is true with worst-case scenario rate increases. The average period of time that people sell their residence is every 10 years, with at least one refinance during that time. Another benefit when using the strategy of reducing the principal balance happens at the time of the initial adjustment. When an ARM loan adjusts, it essentially becomes a new loan where the payments are based upon the remaining years, the new interest rate and the remaining balance. Because the remaining balance is significantly lower when the savings are used to reduce principal, the payment can actually go down even if the interest rate adjusts higher. I’m No Gambler Many people don’t want to ‘take a gamble’ with an ARM, so they stick with a fixed rate. Like it or not, what ever your choice is, it's a gamble. Selecting a fixed rate loan is betting that, during the time you are obligated to pay the mortgage, the fixed will out-perform the ARM. Either way, it’s a bet. In one you’ll always know the payment amount. Pencil it out to see if the odds to work in your favor. Back to The Future Over the past 200-years, interest rates on the US 10-year Treasury Note have, for the most part, remained fairly tame. The average has been close to 6%, but many fear the chance of runaway double-digit rates. Rates have remained in the single digits for all except 8 of the 214 years shown below. The rampant inflation of the late 1970's had to be reigned in. So rates were pushed higher during the 1980's. The result…low inflation and rates over the years leading to the present time. The lesson learned by the Fed was to use an ounce of prevention instead of a pound of cure. In other words, the Fed acts quickly now to hike rates a little so that inflation will remain in check, which helps keep rates from running significantly higher. The sky-high rates of the early 1980's will probably never be seen again. I Agree With You But… But…"Even though I know I will have saved the money in cash or equity during the first five years, I still may be faced with significantly higher payments to make. Where will I come up with the extra cash flow to pay the higher payment of, perhaps, $500 per month?" The answer is simple but not obvious at first. Let's understand what would make rates skyrocket for 8, 9, or 10 years. The overall economy would have to be very strong, almost too strong, to see inflationary pressures causing rates to ascend and remain very high. Much of those inflationary pressures would come from employment wages rising at a torrid pace…perhaps 10% per year or more. But let's assume the borrower is on the very low end of pay increases, and only sees an average increase of 4% each year. If their household income were $80,000 today and they were concerned about the possibility of a $500 increase in monthly payment 9 years from now, it sure would appear scary against today's income. But they really need to consider what their future income will be. Even at a very modest 4% annual gain, which could be less than half the average annual gain in a hot economic climate, their $80,000 annual income will swell to almost $110,000 in 9 years. That means they would have an extra $2,500 each month to help pay the additional $500 possible bump in their mortgage payment. Sound far-fetched? An easy way to relate to the increase in future income is to work backwards. This same formula would mean that income 9 years ago was $58,000…No longer far fetched. Void Where Prohibited, May Cause Drowsiness and Your Mileage May Vary Though most all of the above examples were given under the worst-case scenario for the ARM loan, the results appear quite favorable when compared to the fixed. But, that said, the wide variety of ARM loan types and their specific features require that each loan option be examined individually…thus, the above disclaimer. Getting a competitive rate is only part of a winning mortgage strategy. By taking the time to explore your options, you’ll likely select the loan that fits your goals and financial plan. |