The
Mortgage Bankers Association reports that only about one of
every ten home mortgages being written today carries an
adjustable interest rate. A combination of negative press on
ARMs and a widespread belief that interest rates are bound
to start rising in the near future has induced extreme
caution among borrowers -- as if the only proper response to
risk is its complete avoidance.

But
risks are worth taking when the benefits are large, and the
downside is known and manageable. This is the case for
hybrid ARMs that have a fixed-rate period of some years at
the beginning before annual rate adjustments kick in. My
impression is that too many borrowers are taking FRMs as the
easier path without considering whether an ARM might serve
them better. The purpose of this article is to describe the
factors that prospective borrowers ought to consider before
making a decision on whether they want an FRM or an ARM.

__
The Choices__

On June
9, well-qualified borrowers using my web site were offered
the following choices: a 30-year fixed-rate mortgage at 4%,
a 10/1 ARM at 3.5%, a 7/1 ARM at 3%, and a 5/1 ARM at
2.625%. (Fees and charges were about the same for all 4 and
all have terms of 30 years). The initial payments on these
loans are calculated using these rates. On a $300,000 loan,
for example, the initial payments, in the same order
starting with the FRM, were $1432, $1347, $1265, and $1205.
The rate and payment on the FRM are fixed but on the ARMs
they can change.

__
How the ARMs Work__

The
initial rate and payment on a 10/1 ARM holds for 10 years.
At the end of the 10-year period, and then every year
thereafter, the rate is adjusted to equal the value of the
rate index at that time plus a margin of 2.75%. The index
right now is 0.1%, which contributes to the view that rate
increases are inevitable.

At each
rate adjustment, the payment is recalculated at the new rate
over the period remaining. No rate change can exceed 2%,
however, and the maximum rate cannot be more than 6% above
the initial rate. The 7/1 and 5/1 ARMs are exactly the same,
except that the first rate and payment adjustments occur
after 7 years and 5 years, respectively.

__
Mortgage Life is Critical__

If
borrowers knew with certainty how long they will have their
mortgage, their decision process would be relatively simple.
If their expected mortgage
life was less than 5 years, they would take the 5/1 ARM
which has the lowest rate, and they would be out of it
before the first rate adjustment. As their time horizon
lengthens, at some point they would shift to the 7/1, then
to the 10/1, and finally to the fixed-rate.

While
very few borrowers know with any degree of certainty how
long they will have their mortgages, most can hazard an
informed guess. This guess should
be an important part of their mortgage selection process.

__
The Benefit in Cost Savings__

The
purpose of taking an ARM rather than an FRM is to reduce
costs, but there is the risk that if interest rates rise and
the borrower keeps the ARM too long, its cost will be higher
than that of the FRM. But how long is too long?

To
answer that question, I calculated total mortgage costs year
by year for the FRM and for the 3 ARMs noted above. For the
ARMs I did it on the assumption that interest rates
increased by the largest amount permitted by the loan
contract – a worst case.
This allowed me to answer the following question: if
ARM interest rates increase as much as possible, how long
must the borrower have the mortgage before the lower cost of
the ARM than the FRM becomes a higher cost?

As an
illustration, if the borrower takes the 5/1 ARM and doesn’t
pay it off until year 6, he still comes out way ahead. The
total cost of the ARM would actually be lower until year 9.
On a 7/1 ARM, the borrower benefits if she is out of the
mortgage before year 11, and on a 10/1 ARM before year 13. I
calculated these numbers using calculator 9ai on my site.

__
Capacity to Bear Payment
Risk__

An
important factor in the mortgage-type decision is the
borrower’s capacity to meet the larger payment resulting
from an ARM rate increase. Because ARM rates are capped, it
is possible to calculate the highest possible payment that
would result from a worst-case interest rate scenario. For
example, if the interest rate on the 5/1 ARM rose from
2.625% to 8.625%, which is the largest increase the contract
allows, the payment on a $300,000 loan would rise from $1205
initially to $2124 in month 85. The largest payments on 7/1
and 10/1 ARMs would be $2132 reached in month 109, and $2131
in month 145. Readers can find these numbers for their own
mortgage on my web site as Step 2 on the “Find Your
Mortgage” page.

__
Concluding Comment__

The
30-year FRM is a great instrument for borrowers who expect
to retire in their current home, or who cannot anticipate
that they will have the capacity to make higher mortgage
payments in the future. Others ought to consider taking an
ARM. Yes, interest rates are bound to go up, but rates were
bound to go up four years ago, and here we are.

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