1.Initial
Interest Rate
This is the interest
rate the ARM loan starts out at. It is always lower than comparable
FRM loans. For example, a 30-year
FRM might carry a fixed interest rate of 8 percent, while a 30-
year ARM might
start out at 6.5 percent (of course, it will not stay at 6.5%).
In this case, that 6.5 percent is the rate on which your loan repayments
are based during the first period of the loan. When the adjustment
date comes along (commonly once each year on the anniversary
of the loan being issued), the lender may, and typically does,
change the rate. So, on the adjustment date, your initial 6.5 per-
cent ARM might
become a 7.5 percent loan, or even a 6 percent loan.
Naturally, if
interest rates are rising, your loan will be adjusted to a higher rate,
and you'll pay more each month. The oppositeis true
if rates are lower in the market-your payment will reduce. No
one can foresee
what interest rates are going to do in a year's time. However,
general trends are sometimes predictable. So, if you are considering
an ARM, talk with financially savvy people whose views you trust. If
you conclude that interest rates are likely to move in
one direction or the other, this will become one of your considerations
in choosing a loan.
Two advantages
of ARMs are that the initial lower interest rate makes it an easier
loan to qualify for, and the lower payments at the beginning
are easier on your household budget. In fact, ARMs frequently work out
cheaper overall if you plan to remain in the house for
a shorter time-three to seven years, for example. But that depends,
also, on the difference between the ARM and FRM interest rates
when you take out the loan, and how the ARM rate changes along
the way. Does that mean ARMs are a gamble? Yes!-but only when
you stay beyond the initial fixed-rate period Over shorter terms the
gamble often pays off. Plus, there are safeguards on all ARMs, which
we'll examine as we proceed.
Let's now consider
a common situation: We'll assume you want and can qualify for a $100/000
loan at the higher FRM interest rate (higher than an ARM'S initial rate).
Your loan options might looklike this:
Option 1:
$100,000 FRM 8%, 30 years. Monthly payment (won't change): $733.77
Option 2
: $100,000 ARM 6.5%, 30 years. Monthly payment (will change):
$632.07
As you can see,
this ARM will save you $l0l.70 per month in the first year. After 12
months you'll be ahead by $1220.40 ($101.70 x 12)
.That's $1220.40 after taxes, equal to $1,500 to $1,600 gross.
Now let's assume
this ARM'S interest rate fluctuates moderately over the first four years.
Here's how your monthly expense, annual loan cost, and your total out-of-pocket
costs will differ between the two loans:
Year 1:
FRM 8%: $733.77 x 12 = $8805.24 ARM 6.5%: $632.07 x 12 = $7584. 84
Year 2:
FRM 8%: $733.77 x 12 = $8805.24 ARM 7.5%: $697.84 x 12 = $8374. 08
Year 3:
FRM 8%: $733.77 x 12 = $8805.24 ARM 8.0%: $731.01 x 12 = $8772. 12
Year 4:
FRM 8%: $733.77 x 12 = $8805.24 ARM 7.5%: $698 50 x 12 = $8382.00
Total Paid: $35,220.96
$33,113.04
So, in this hypothetical
comparison, after the first four years the ARM will have saved you $2107.92
($35,206.96 minus $33,113 04)The average annual interest rate you paid
on the ARM was 7.375percent, as against 8 percent on the FRM. Bear in
mind, also, that theARM was easier to qualify for, and that the monthly
repayments were lower in three of these first four years.
But now let's make
some further assumptions about how the ARM interest rate fluctuates over
the next four years (years 5, 6, 7, and
8), and review the situation at the end of the eighth year.
Year 5:
FRM 8%: $733.77 x 12 = $8805.24 ARM 9.0%: $795.52 x 12 = $ 9546 24
Year 6:
FRM 8%: $733.77 x 12 = $8805.24 ARM 9.5%: $828 23 x 12 = $ 9938
76
Year 7:
FRM 8%: $733.77 x 12 = $8805.24 ARM10.5%: $893.62 x 12 = $10723 44
Year 8:
FRM 8%: $733.77 x 12 = $8805.24 ARM 10.5%: $893.62 x 12 = $1072344
Total Paid: $35,220.96
$40,931.88
As you can see,
after year 8 the ARM'S earlier advantage has been wiped out, due entirely
to interest rates rising as they did. It's quite
possible, of course, that rates might have fallen, or remainedaround
their initial low level (unlikely). But it's also possible theymight
have risen even more steeply However, in this example as itstands at
the end of year 8, the FRM has cost you $3,603 less than theARM. Let's
see the figures side by side:
Cost of ARM,
up to end of year 8: $74,044.92 ($33,113.04 + $40,931 88)
Cost of FRM,
up to end of year 8: $70.441.92 ($733.77 x 12 months x 8 years)
Difference: $
3,603.00
Look closely
at the math in this example and you'll see that it is only in the seventh
year that the ARM becomes more expensive overall. By adding the first
six years of payments for both loans you'll see they work out virtually
the same. And that the average interest
rate on the ARM over those first six years is exactly the same
as the FRM rate—8
percent. This shows why ARMs are often a better choice for homebuyers
who plan on holding the loan for three to seven years.
But this argument
also assumes you'll be able to get a 2 to 3 percent lower initial interest
rate on the ARM. That has typically been the case, but as I write the
differential is just 1 to 1.8 percent. The other assumption here is
that interest rates do not suddenly shoot up, sending your ARM rate
sky high. The extent to which an ARM'S interest rate can increase is
limited by caps, which we'll get to shortly.
When home loan
interest rates are low, the difference between initial ARM rates and
FRM rates shrinks, making fixed-rate mortgages more popular. However,
as interest rates rise above 8 percent,the spread between ARM and FRM
rates increases again (the difference is often 3%), and ARMs become
more attractive.
For all these
reasons, if you tend to be overanxious about risk, an ARM might cause
you more worry than it is worth. Your psychic happiness must figure
strongly in your decision. For many borrowers, predictability and peace
of mind cannot be sacrificed, even when the risk is low or moderate.
Note; With one-year
ARMs (1/30, 1/15, for example), keep in mind that lenders do not use
the ARM'S initial interest rate when qualifying the borrower (that is,
determining the borrower's ability to make the repayments on the loan).
Instead, they use a higher rate,for extra security for the lender. Here's
an illustration: On a 6.5 per-cent ARM, the lender will expect the borrower
to qualify as if the loan was at 8.5 percent (6.5% plus 2%). In other
words, in the qualifying calculation, the lender pretends the borrower's
initial interestrate and monthly payment will be higher than is actually
true. The rationale is that the borrower might, in year 1, be able to
handle the initial low monthly payment (at 6.5% in this example), but
might not be able to pay a higher monthly payment in year 2, when the
ARM'S interest rate could increase by 2 percent (to 8.5%). This qualifying
method is typically not applied to multi year ARMs: 3/1, 5/1,or 7/1
ARMs, for example. More on this shortly.
For most borrowers
planning to hold a home loan for longer than six or seven years, a low-interest-rate
FRM will usually be a better choice. The problem, of course, is that
most new home buyers cannot predict how long they will stay in a particular
home. National surveys report that, on average, homeowners terminate
their loans within the first 7 to 10 years (they pack up and move onto
another home). So, be sure to get a lender or mortgage broker to show
you comparison payment projections for different types ofloans over
varying periods of years.
One group of
borrower's to whom ARMs are often particularly appealing are those with
very large loans. On loans of $300/000 andup, a borrower can often save
more money by frequent refinancingwhen their current ARM'S initial lower
rate is due to end. Refinancing is not cheap, but the money saved with
this strategy can coversuch costs, with a tidy sum left over. But, as
is always the case whenloan shopping, you must first run the numbers
side by side.
