Adjustable Rate Mortgages – You’re Kidding Right?

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.

Adjustable Rate Mortgages – You’re Kidding Right?
Adjustable Rate Mortgages – You’re Kidding Right?

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?

( Photo by ilovebutter )

11 Responses to Adjustable Rate Mortgages – You’re Kidding Right?

  1. What amazes me about these kind of deals is that folks “jump” at them and don’t even talk with others about it or read the famous “fine print” = end up signing up for stuff they had no idea they had(lol).

    Read, research and discuss = reduces the chances of getting into a situation that is not good for you. And be PATIENT. I know I am famous for wanting stuff to happen like “yesterday” – they call it the microwave age…

  2. Hi Angela–With ARMs I’m not even sure it’s the fine print–it’s the whole deal. Why take a chance with your home, especially after what’s happened over the past few years!

  3. Kevin – the pro-ARM guys will suggest you can put the extra money against principal for the 5 years, and see that by the end of year 5, you’d be $27K to the better with the ARM. But. Once rates go up, you’d find the ARM payments are nearly $2700 vs the $2079 on the fixed, and that difference wipes away the savings pretty quickly.
    I’d not suggest anyone risk this.

  4. Hi Joe–I agree. There are different ways to turn the numbers on an ARM so that it seems like an advantage, but I see mortgages as patient debt–the kind you pay each month and forget about otherwise. We shouldn’t be taking any kind of risks with the homestead, there’s enough of that these days now that we know that houses can drop as well as rise in value.

    Also, I don’t see anyone paying the savings into principal–that defeats the purpose of the lower payment that borrowers usually seek with ARM loans. And for the most part, if you’re taking an ARM you aren’t doing it to payoff the loan, but to keep the payments at a minimum. The money manipulations claimed on ARMs is mostly theory.

  5. I’m going to respectfully disagree (to a point), as an ARM has worked out great for us. 8 years ago when my wife and I built our home, we did a 5/1 ARM at a great rate. The three years it has adjusted since then (after the 5 years), my mortgage payment has dropped each time due to falling interest rates. Yes, the savings is somewhat offset by the reduction in tax deduction, but we have saved money over a 30 year loan for the entire existence of our loan thus far. My current interest rate is 3%!

    Something that you have to keep in mind is that interest rates don’t shoot up from 3% to 12% overnight. The people that tend to get into trouble with ARMS are those that are unable to refinance, ie, people that took out an ARM to buy the absolute most house they can.

    For myself, I’ve enjoyed a very low interest rate for a significant period of time at quite an overall savings. When signs start pointing at interest hikes, I’ll immediately call my bank and lock in.

    Until then, I’ll continue to enjoy my 3%. 🙂

  6. Hi Travis–I have to respectfully disagree with your respectful disagreement! 😉 What you’re describing is the history of ARMS, not the future. Now none us know the future, but what we do know is that rates dropped from the mid-teens in the early 1980s down to lowest levels in recorded history of late. That scenario has most definately favored ARM loans!

    But where do we go from record low interest rates??? UP is the only direction left (unless we assume that the economy will continue to deteriorate bringing on even lower rates). T

    his is one of those classic examples of “past performance is not a guarantee of future returns”. I wouldn’t bet against higher rates in the near future. And here’s something else to keep in mind about interest rates: they go up much more quickly than they go down. I was in the mortgage business for many years and learned that a two point drop in rates that took two years, can be undone in two months on the way up. Rates are determined by the bond market, where panic is a much more powerful force than optimism.

    Thanks for a different perspective.

  7. Travis/Kevin M,

    You guys are funny. Now it’s my turn to chime in.

    Travis- I got an ARM as well, I knew what I was getting into, but we’ve been paying additional principal every month to “think” that we’re on a 30 year mortgage. I can definitely see how financially responsible people can benefit from an ARM, but I’ll have to agree with Kevin M on this.

    We’re looking into refinancing into a 30 year mortgage, even though our rate will be almost the same. Not much savings, but since 30 year rates are at a record low, why not?

    With ARM rates being so low, the chances that your interest rate will be lower or remain the same is slim. I think anyone in an ARM right now should try to refi into a fixed rate, even if their payment stays the same or slightly increases.

    Underwriters need to see some type of benefit for a refinance, whether it’s a cashout or monthly payment. Even if you switch from an ARM to a fixed rate, it’s still considered a benefit regardless of your new monthly payment.

    I still think people that got their interest rate lowered after they adjusted were lucky as heck!

  8. Hi Kevin–I do realize that, generally speaking, ARMs have been superior to the fixed UP TO THIS POINT. But the wind will change and when it does everyone with an ARM will be kicking themselves for not getting out while rates were at record lows. I don’t know that it’s possible to time the very bottom of the rate picture, but I don’t think now is a good time to press that effort to the hilt. As the saying goes, “better a month early than a minute late” and when it comes to rates that’s good advice.

  9. Nothing wrong with taking an ARM, as long as you know what you’re signing. At least the worst is over from the 2007 housing collapse, where everyone complained that they didn’t know that their adjustable mortgage could change rates and therefore payment amount…

    Currently, I took a 30 year fixed as a new homeowner, but if some can afford to pay off the mortgage and is choosing not to, an ARM makes perfect sense.

  10. I agree Mark. But realistically, how many people have enough money to pay off the mortgage? That being the case, the fixed rate is the better choice for the 95%+ of homeowners who can’t afford to payoff the mortgage.

  11. While in reality most people can’t afford to pay off the mortgage, I have to disagree with you. People not being able to save or properly manage their money is not a reason to to be against something that fluctuates instead of a fixed rate.

    In your first reason against ARMs, the customer has an extra $264 per month ($15,840 over five years) that could have been compounding with interest for the homeowner. Additionally, even if the rate doubles at Year 6, the homeowner has years before they even start spending more than the fixed mortgage would have been. The issue with ARM’s lies in the fact that people tend to find ways to spend the difference in payments rather than knowing the reality of what they signed off on.

    (This again ties back to what people should be able to do and not what they actually do) 99% of people who truly want to pay off the mortgage early (or at least be able to afford to do so) are capable of doing so. It’s only a matter of choosing to do so via spending less, earning more, living in a lower cost area, etc.

    Lastly, a $400,000 mortgage? Most people shouldn’t be buying a $500,000 house (20% down), even in the Northeast. Average household income = $50,000, or 10% of the purchase price. Why not aim for a 2-3x’s income to keep it more manageable?

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