Are people still taking adjustable rate mortgages, or ARMs? Apparently so. An article came out last week extolling the virtues of ARM loans. The article states, among other things, that ARMs may be an “even better deal than fixed mortgages”, the spread between ARMs and fixed rates are the widest in eight years, and that ARMs are a good loan for people who are “dead certain” they are going to sell within the fixed period of the loan.
Now, in the article’s favor, there is a certain rate advantage in the short term. The article notes that the average rate on the 5/1 ARM – the primary loan in the discussion – is now 2.67%, compared to the average rate on a 30 year fixed rate loan of 3.87%. The 5/1 has a fixed rate period for the first five years of the loan, then adjusts each year there after, subject to a 2% annual cap, and a 5% lifetime cap – meaning the highest the rate could ever go over the life of the loan is 7.67% (OUCH!!!). But the article gives the example that on a $400,000 loan, you could save over $3,000 per year in interest.
Fair enough – but I still say balderdash!
And I can think of at least 7 reasons why ARMs are a bad deal:
1. The monthly savings doesn’t justify the additional risk of an ARM.
According to my mortgage calculator, a 5/1 ARM at 2.67% on a $400,000 loan carries a monthly payment of $1,616; the 30 year fixed at 3.87% is $1,880 per month. You’ll save $264 per month, or $3,168 per year, with the ARM. I don’t know about anyone else, but to me saving $264 per month on a $400,000 loan doesn’t come close to justify living with the ticking time bomb that awaits the homeowner at the end of five years.
2. Tax savings will nullify at least some of the interest rate savings on the ARM.
If you’re in the 28% marginal tax bracket for federal income taxes, and a 7% marginal rate for your state income tax, any interest savings will be reduced by 35% total. That means that the $3,168 annual ARM savings from above will be reduced by $1,109, or net out at $2,059. That makes the payment savings that much less attractive.
3. Mortgage prepayments will not shorten your loan term.
This is a dirty little secret of ARM loans. No matter how much you pay down your loan, it will still run for 30 years! (Your payment is recalculated at the remaining outstanding loan balance at the time of adjustment, and is always based on a 30 year payout.) The payment will fall – that’s an unexpected plus – but you won’t be able to pay it off sooner by making prepayments. However – if interest rates rise over the term of the loan, your payments might not drop either!
4. Interest rates are near all-time lows.
If you can lock in a rate of 3.87% that is FIXED for 30 years why would you trade that for just five years of 2.67%? 30 year money nearr historic lows should be taken on instinct.
5. You surrender your options and assume all the risks.
With the 30 year fixed rate you know what you’ll be paying, come what may. If interest rates fall, you can refinance to the lower rate; if they rise, you don’t need to do a thing. With the 5/1 ARM you’re good for five years and then, unless rates fall by then, you’ll have to pay what ever the rate is at that time – subject to the loan caps – and that can have you eventually paying as high as 7.67%. At that point, you’ll start giving back some of the interest rate benefit you received in the early years of the ARM.
Also, if interest rates go that high, you may not be able to sell your home, at least not for anything close to what you paid for it. Higher rates generally translate to a less robust housing market. And as tight as this market is, it wouldn’t take much of a rate uptick to cause problems.
6. You can’t KNOW that you’ll be selling within five years
The article says that a 5/1 ARM can work well if you’re sure you’re selling within the five year fixed rate period. But even if you could know that you’ll be selling, how do you know what the housing market will be at that time? What the 5/1 ARM really does is define in advance what you must do in a certain time period. That might not be so bad if you could also know for sure that market conditions will cooperate – but you can’t!
7. After what’s happened in real estate since 2007 why take the chance?
Taking an ARM loan strikes me as a move that disregards the housing meltdown over the past few years. ARM loans were one of the factors that contributed to the market’s problems because people found that they could no longer afford the higher payments that ARM loans created after rate resets. If the 2007 meltdown did nothing else, it should have imparted a new respect in all of us for the potential risks of homeownership. Taking an ARM loan now is born of the same blind optimism that created the housing bubble in the first place.
What do you think about ARMs? Do you think there’s enough certainty in the housing market to justify taking on the risks that ARMs bring? Or do you agree with me that ARMs border on insanity?