10-14-05
BY MIKE MCNAMARA
“Should I get a fixed rate or an ARM?”
This important decision has puzzled just about every home buyer who has ever shopped for a loan. What is an ARM? When should you go with an ARM? When shouldn’t you?
What is an ARM, anyway?
As its name implies, an Adjustable Rate Mortgage (ARM) is one in which the rate changes (adjusts) on a specified schedule after an initial “fixed” period. That initial period can be anywhere from one month to 10 years; the shorter the time span, the lower the rate. Over that initial fixed period, you will enjoy a rate that is better than the standard 30-year fixed rate mortgage.
But what happens after that initial time period ends and your mortgage rate begins to adjust? The amount of the rate change (referred to as an adjustment) will be determined by a mathematical formula based on a particular index, the most common being the 1-Year U.S. Treasury Bill or the Cost of Funds Index (COFI). Most adjustable rate mortgages have a lifetime rate cap (also called a ceiling), which limits the amount the interest rate can increase over the life of your loan. Most adjustable rate mortgages also have a periodic rate cap, which limits the amount of the rate increase for each adjustment. The lender typically will adjust your ARM rate upward by a maximum of 2 percentage points a year (that’s the periodic cap), and a max of 6 percent over the entire loan period (that’s the lifetime cap).
For example, a five-year ARM that starts out at, say, 5.5 percent can increase to 7.5 percent in the sixth year, to 9.5 percent in the seventh year, and to 11.5 percent in the eighth year. Kinda scary.
Basically, once that “fixed” period expires, an ARM can be pretty risky for a homeowner. By contrast, a 30-year fixed rate loan locks in your rate for the life of your loan—there’s no need to guess as to where the rate will be next year or in 15 or 30 years.
When to go with an ARM
In general, it all comes down to how long you plan on living in the property and/or whether you are likely to refinance.
For example, if you expect to move or sell within three to four years, or if you are likely to refinance over that period of time, it might make sense to go with a five year ARM. You will save money with the lower rate over the first five years and you will be done with that mortgage before the rate begins to adjust.
You might ask, how can someone be likely to refinance? Doesn’t it count on market rates and other factors out of our control? If you have a first and second mortgage, it is likely you will refinance to get rid of that second lien in two to three years, as your property appreciates and you build equity in your home. Even if rates have risen a bit over that time, the money saved by removing that second mortgage payment will likely surpass any extra interest paid on the first mortgage due to a slightly higher rate. To refresh your knowledge of second mortgages, avoiding Private Mortgage Insurance (PMI) and the 80/20 programs we discussed in earlier issues, you can head to www.performink.com, click on “Owning a Home” and check out the 8/5/05 and 12/24/04 articles.
When not to go with an ARM
If you are going to put 20 percent down on a property and are unsure of how long you will be living there, you should probably go with a 30-year fixed. By putting 20 percent down, you would not need a second mortgage to avoid paying PMI, so the only reason you would ever need to refinance would be if rates improved significantly. Since we cannot predict when that is going to happen, it would make sense to go with a rate that is fixed for the life of the loan.
Be Careful!
Finally, borrowers should be careful that ARMs do not incur “negative amortization” (also called “deferred interest”). With a few ARMs, the minimum required payment is not enough to cover the interest due. On these loans, the difference between the amount paid and the actual interest due is tacked onto the principal each month, i.e. the borrower ends up owing more than he borrowed. This type of loan, common in the early ’80s when rates were high, has recently reappeared in a new form. Loans advertising an excessively low payment rate like 3 percent often have this feature. Again, the lower payment may make this type of loan worth it to you, but it is important to know what you’re getting yourself into.
In Conclusion
An Adjustable Rate Mortgage (ARM) is a great option for home buyers who plan to live in their new abode for five years or less. It is also good for folks that have a second mortgage or are currently paying Private Mortgage Insurance (PMI), as they will more than likely want to refinance within two to three years.
As with all of these important issues, it is imperative that you discuss them in detail with your loan officer before making a decision. The purpose of this article is not to settle this issue for you, but instead to give you a strong foundation of knowledge so that you are well informed when you meet with your loan officer.
Feel free to call or e-mail me anytime with any home buying questions you may have. Also, please send me any comments or suggestions about this article and let me know if there are topics you would like to see discussed. Talk to you next month!
Mike McNamara has been an actor in Chicago for the past seven years in theatre, commercials, television and film. Mike is also a Mortgage Consultant and Loan Officer with West America Mortgage Company. He can be reached anytime at 773/398-0021 or McNamara310@aol.com. Special thanks to Jim Morley, assistant vice president of West America Mortgage Company (and Chicago theatre actor) for contributing to this article.