Adjustable rate mortgages, otherwise known as ARMs, are scary to many new home buyers. People often look for conventional fixed rate mortgages, because they think they are safer. That can be shortsighted in the long-run, however. Smart home buyers and home owners looking to refinance who study the facts ahead of time are more likely to choose the adjustable rate mortgage options for several reasons. Just look at the current figures. People who have current adjustable rate mortgages that are entering the adjustment period are looking at massive savings. Interest rates are lower than they have been in recent history, and an ARM adjustment will mean an automatic savings on monthly payments, and the overall interest paid on the loan.
With interest rates standing at less than 3%, home owners who financed with ARM mortgages in the last five to seven years have proven how wise this type of mortgage is. Even with proven savings, some home owners are anxious to refinance away from an ARMs mortgage. Freddie Mac reports that more than ¾ of the refinance mortgages in the last year were home owners changing from an adjustable rate mortgage to a fixed rate mortgage. These decisions are usually made out of fear. Home owners who have an adjustable rate mortgage should consider all of the options and may be wise to keep their current mortgage style, even when refinancing for other reasons such as cash-out.
IS AN ARM MORTGAGE A GOOD CHOICE FOR THE LONG HAUL?
The reason so many home owners seem in a hurry to get rid of an ARM is the fact that they carry a sense of the unknown. Since there is really know way to know exactly what will happen with interest rates over the full term of a loan, it is more comfortable to get into a conventional non-adjustable rate mortgage. The problem there is two-fold. First off, many new home buyers have a hard time qualifying for standard fixed rate mortgages. ARM mortgages are more flexible in their requirements, so they are often the best choice for a new home buyer. The biggest problem, however, with settling for a non-adjustable rate mortgage is that the interest agreed upon at the start of the mortgage is the interest rate that must be paid throughout the loan term regardless of what happens economically. That can mean a huge payout of interest over a similar ARM mortgage when interest rates fall.
Over the course of an ARM mortgage the adjustments will go up and down frequently. The interest rates adjust according to the market conditions of the time. That can be difficult for some households to manage if they are on a fixed budget. As frightening as an ARM can be, the rewards can be considerable. In just the last 12 years, starting in 2013, homeowners with ARM mortgages have found themselves on the winning side of the mortgage interest scenario. They have “beat the bank” at their own game, so to speak.
The reason for that success is that interest rates have fallen considerably during that time, so instead of paying a flat, fixed rate, they have consistently had lower payments every year and paid far less interest than their standard fixed rate counterparts. Today’s interest rates are lower than they have been in recorded history. For homeowners looking to refinance, or new home buyers considering the type of mortgage to obtain, here is a quick breakdown of how an ARM mortgage works.
1. The initial period of the loan which lasts between 5 and 7 years, is a standard, fixed loan where the interest rate remains the same as agreed upon at the beginning.
2. At the end of the agreed period, the interest rate on the loan will fluctuate according to a formula set at the start of the loan.
3. Every year from that period onward, the loan will adjust to the economic conditions of the time using the preset formula.
The formula used to calculate mortgage interest rates on an ARM is simple. The formula is the sum of various variable interest rates, usually the LIBOR, and a consistent figure, usually 2.25%. The constant is added to the variable for a new overall rate. In today’s figures the formula would look like 2.25 plus 0.66 for a total interest on the loan of 2.91%.
2.91% interest is low for a mortgage rate by just about any standards. In addition, a home owner with an ARM mortgage will not have to pay any fees for the change in rates, go through an approval process or worry about rejection like a home owner who is trying to refinance a standard fixed rate mortgage would to get a new low rate in the current market. The change is automatic. The home owner does not even have to be aware of the market conditions or think about current interest rates at all.
Everything is done by the lender. There are no requirements, no credit checks, no appraisals, no verification of employment or income, nothing. Not even an underwriting process and certainly no closing costs. It isn’t a new loan. It is the same loan doing what is already agreed up on at the initial signing.
An ARM adjustment will happen regardless of the value of the home, it happens even if your employment has changed or income gone up or down. Home owners with an ARM loan get the best rates available every year, once a year, no matter what their situation. Standard ARM loans have gone down in their adjustments for 5 out of the last 6 years.
SHOULD YOU KEEP AN ARM MORTGAGE OR SWITCH TO A CONVENTIONAL FIXED RATE LOAN?
This can be a tricky question for a home owner with an existing ARM. A loan that is entering an initial adjustment period at this time in history is in a good position, and about to take a major reduction in interest that will mean saving a lot of money on monthly payments for at least a year without paying any closing costs or going through an application process. For some, however, it may make sense to consider the switch now to a conventional fixed rate mortgage.
The fact that interest rates are so low can make this a good time to lock in those extremely low rates for a long term loan. While getting a mortgage five years ago was harder, and interest rates were higher, making an ARM a good choice, now, the low rates mean a fixed rate will have those low payments for a long time. People who predict an improvement in the economy may feel that the current rates are at an all time low, and this is the time to cash in on those. Another year of an ARM may see a rise in interest. Taking advantage of the current low payments and using the current year to apply for a fixed rate loan that will carry that low interest for 15 to 30 years now may be a great idea.
Improved economic conditions usually mean higher LIBOR rates, the rates that are used to calculate the ARM adjustment. Home owners with an ARM loan have three options.
1. Let it stand as is. Take the lower new interest and wait to see what happens at the next adjustment in a year.
2. Refinance now to a new ARM. This will give you a new initial hold on adjustments. The new low rates will remain fixed for the 5 to 7 year agreed period before changing once more.
3. Take advantage of the new low rates and refinance to a fixed-rate loan now.
All three options have some merit. Letting a current ARM stand, and playing a waiting game to see what happens in the next year may be a good way to go. The rates may continue to drop still more, making the wait valuable and giving home owners yet another chance to refinance at an even better rate next year. If the rates do climb, it won’t be a big impact, and the new interest rate will probably still be far below the initial interest of the loan, and home owners can choose then to refinance to a fixed rate.
Refinancing to a new ARM is a smart move for those who are unsure about changing, but want to lock in the great low rate now. This is especially good for a home owner who thinks they may be moving in the next 5 or 7 years. It will allow them to have the great low interest available now over that time period without worrying about adjustments. It is even likely that a new ARM would have a slightly better interest rate than the adjustable rate change would allow. However, that can be offset by the fact that there will be new closing costs and other fees associated with a new loan.
Home owners who will likely be staying in their homes for the course of the loan may be wise to consider a fixed rate mortgage now with interest rates so low. A fixed mortgage rate takes the fear out of monthly payments. The government reports that 75% of home owners with an ARM will make the switch, with 25% keeping their ARM mortgages or refinancing back to a new ARM.