Ah, adjustable rate mortgages….the duct tape of the financial lending industry. Can’t afford that house of your dreams? Sure you can! Just put the whole thing on an adjustable rate mortgage and you’ll easily be able to make those payments you couldn’t afford on the fixed rate mortgage.
Did I say “easily make the payments?” Well, that’s right….for now.
Most financial advisors worth their salt (present company included, even though I really don’t need more salt) usually recommend against adjustable rate mortgages. Why? Simple: Unless you’re one of those awesome psychics on television, you can’t predict what’s going to happen in the next seven or eight years, let alone 30. If there’s one equation that makes sense for most people, it’s this: fixed rate mortgages relieve you from one of the bazillion worries that you have in your daily life.
Side note:….I was reading a piece recently called “Is the 30 Year Mortgage Dead.” Dead? What could be more alive than certainty? The piece argued that you shouldn’t have a 30 year mortgage because you will never stay in your house that long and will end up paying a ton of front-loaded fees. Agreed. However, there are many reasons for a 30 year mortgage beyond that simpleton thinking. A good stacker looks at the whole forest and avoids getting sucked into the single tree argument.
How Does This Adjustable Rate Mortgage Thingy Work?
For those of you new to the adjustable rate mortgage game, it’s pretty easy: your interest rate is generally lower than the current fixed rate because the bank doesn’t have to guarantee the rate for a substantial amount of time. You win because you get a lower rate. The bank wins because they’re off the hook sooner.
Don’t get it? Try this: Imagine you’re a banker and a customer walks in to borrow $200k. Would you offer a better rate on a 30 year loan where you had to guarantee the rate for 5 years or for 30? Exactly.
After the initial period (which varies from ARM to ARM…often it’s five or seven years.) your rate can change. Generally speaking your rate will float with prevailing rates and there is a cap on the amount that the rate can change per year.
Three fantastic questions to ask before you buy an ARM:
– How much can my rate change per year?
– What rate is the ARM based on and how can I track it?
– Is there a penalty to change loans early?
But just like annuities and whole life insurance have a time and place, so does the adjustable rate mortgage. Here are a few examples:
– You still haven’t refinanced from much higher rates and are close to paying off your loan. A no-point/no cost adjustable rate mortgage might leave your payments low.
– You know for certain that you’re moving in a short time. Why not bury the rate as low as possible?
– You’re working on a strategy that is short term, rather than long term.
I’m sure there are countless other reasons.
When I was practicing financial planning, I saw many studies that showed a superior strategy over long periods of time is to secure a no point/no cost one year arm and refinance constantly. Historically your mortgage rate will be lower by far than with fixed rate loans. This is an extremely aggressive strategy because:
– You have to remember to refinance every year.
– You have to be comfortable with the hassle of the yearly refinance
– Your cash flow has to be flexible enough to withstand (possibly) substantial changes in your payments
What Type of Mortgage Should You Buy?
Your mortgage search shouldn’t begin with “I love 30 years” or “I hate ARMs.” It should start with your overall plan. Remember: Successful businesses build debt strategies around their long term goals. People pay off debt willy-nilly.
Lesson of the day: Don’t do things all willy-nilly.
Today’s Workout: 6 x 1 miles @ 8 minute pace
I’ve run 350 days in a row
Best song on my iPod today: Young The Giant: My Body
Edward - Entry Level Dilemma
When we were searching, an ARM was definitely on our list of possibilities. We were trying to get out from renting (well that didn’t work out so well), but didn’t have enough money saved for a down payment on a “forever” or even “I see myself here in 10 years” kind of place. Instead duplexes and condos were our budget. So, we were open to the idea of an ARM to get a lower rate and continue to save towards a larger down payment for a new place in 5 or so years.
AvgJoeMoney
Often it turns out that buying a home for that length of time is counterproductive (at least financially) between the PMI, RE taxes and everything else. I’m sure you did that math, but I’m curious how it turned out.
Edward - Entry Level Dilemma
Fort Collins is kind of an odd market with low-ish housing prices but high-ish rents. The place we are trying now is actually 50% more expensive than a similarly sized house that my parents rent in NJ.
A 15 year mortgage for this place we be less than my rent!
AvgJoeMoney
That’s incredible…and not in a good way!
Rita P
We are planning for a mortgage loan very shortly and I hope we can keep this ARM also in the list. We need to check what workouts well for us. We are pretty OK with ARM also if it works well with our plan
AvgJoeMoney
It’s a more difficult pick now than it was 6 months ago.
Holly Johnson
We considered an arm last time we refinanced. We ended up refinancing into another 15 year fixed mortgage, but I wouldn’t rule out an arm in the future.
AvgJoeMoney
This may apply to you more than most since you’re moving soon. Do you see yourself staying in your new home for a long period of time?
Mrs PoP @ PlantingOurPennies
If interest rates were higher I’d consider an ARM, but we chose to lock in our 15 year loan at 3.25% and feel pretty comfortable taking our time to paying off.
AvgJoeMoney
I have a 30 year personally, and have no regrets about stretching out the mortgage payments while I save enough to pay it down quickly into a “tell my lender to shove off” fund.
moneystepper
My latest mortgage I took out was a 4 year fixed loan at 6.5% and within 6 months, the variable rate had fallen to 0.5%, but the high repayment charges made it a bad investment decision to change mortgages.
I didn’t enjoy the following 4 years very much!!
Can you guess where I was on this graph?
I’ve since moved onto the variable rate, and so had a bit of a hatred towards fixed deals since.
However, given the loans rates available today, I would definitely take a fixed for the longest period I could (10 year is currently the longest you can take in the UK) to give me the security of knowing my payment amount each month no matter what happened in the economy (especially useful for any BTL planning).
AvgJoeMoney
Ugh….my stomach aches just looking at that graph. What a nightmare for you.
Done by Forty
We paid off our 15 year fixed so early that I wish we’d tried an ARM…but that’s easy to say in retrospect. Had I lost my job or suffered big medical expenses, the last thing I’d want is an adjustment in the wrong direction.
AvgJoeMoney
Great point. If you don’t have a cash reserve and aren’t prepared for the big swings an ARM can create, you’re probably doing it for the wrong reason.
Laurie @thefrugalfarmer
I’m way too paranoid to consider an ARM – too many “what ifs” for me. 🙂
AvgJoeMoney
Precisely why most advisors tell people to ignore ARMs. There are so many things that can go wrong….
Matt @ momanddadmoney
“Your mortgage search shouldn’t begin with “I love 30 years” or “I hate ARMs.” It should start with your overall plan.”
Love that line. My parents just bought a vacation home (lucky them!) and they took out a 5/1 ARM because they find it hard to envision a scenario where the mortgage isn’t paid off in less than 7 years or so, and most likely within the 5. I think the rate they got was like 2.6% for those 5 years. I definitely think there’s a time and place if you’ve thought through how it fits into your overall plans.
AvgJoeMoney
2.6%….that’s awesome. Sounds like they have a great strategy.