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April 14th, 2011 (Modified on May 30th, 2017)

Are you disciplined enough for an ARM?

by Peter Miller


int rate QMarkCurrent mortgage rates for 30-year fixed rate loans are still at historic lows. Granted, they may not be as low as they once were, but in the grand scheme of things, these mortgage rates are still fantastic. That said, borrowers looking to land an even lower mortgage rates are considering adjustable rate mortgages (ARMs).

Would you be better off with an ARM, even though current fixed-rate loans are not far from their rock-bottom lows?

According to the latest issue of HSH.com’s Market Trends Newsletter, their weekly Fixed-Rate Mortgage Indicator (FRMI) found that the overall average rate for 30-year fixed rate mortgages remained unchanged last week at 5.17%, and the 5/1 ARM average was 3.85 percent. If you borrowed $100,000, the initial monthly cost for both principal and interest would be $547.26 for the fixed-rate product and $468.24 for the ARM.

One pro’s advice

Jack M. Guttentag, Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania, makes the point that borrowers might be better off with the ARM, especially if they make the higher monthly payments that would be due if they had selected a fixed rate mortgage.

“The best way to do this,” he said, “and in most cases a relatively painless way, is for the borrower refinancing into an ARM to continue to make the larger FRM [fixed rate mortgage] payment. This accelerates reduction in the loan balance, so that if the borrower still has the mortgage when the ARM rate adjusts, any payment increase will be smaller.”

This logic makes a lot of sense. In effect, if the borrower chooses a 5/1 ARM let’s say, for the first five years of the loan term the borrower is getting more amortization because the payment is the same as the fixed-rate mortgage but the interest rate is lower. Combine the fixed rate mortgage payment with the lower interest rate of the ARM and you get larger principal write-offs each month.

To learn more about adjustable rate mortgages, be sure to read:

“ARMs: How’s, Who’s and Why’s
What You Need to Know About Adjustable Rate Mortgages”

Into the future

But what happens at the end of five years?

That depends on the construction of the ARM. It could happen that at the end of five years an index declines, in which case the ARM will continue to be cheaper that the fixed-rate loan. But what if rates go up?

If rates increase by 2 percent, we then have an adjustable rate loan at 5.85 percent with a 25-year term and a principal balance of $90,211.59. The new monthly payment for year six would be $572.44 — not much more than the fixed-rate loan we discussed above.

So far the example works very much in the favor of the ARM. However, life may be different and a little less predictable.

ARM payment increases

Suppose our ARM borrower owns the property for eight years. Using HSH.com’s mortgage amortization calculator we can see that if the interest rate is allowed to increase 2 percent annually to a maximum of 6 percent above the start rate, then the fixed-rate borrower could be far ahead, both financially and otherwise:

1.  Years 1-5: $468.24  

2.  Year 6: $572.44

3.  Year 7: $696.08

4.  Year 8: $814.34

Now it can be argued — and will be argued — that the ARM borrower is still ahead. After all, after eight years your income will likely increase. Also, if the ARM borrower made the fully amortizing payments as Professor Guttentag suggests (instead of the lower ARM payments in the first five years of the loan), then the monthly costs in the later years will be lower than shown in the breakdown above.

The real world

The catch here is those larger monthly payments. It’s a great theory, the math is excellent and the logic is, well, logical. But the reality is different.

I have very little hope that many borrowers will make anything other than the lowest possible monthly payment. I not only have very little hope, I also have research.

A 2009 study by Fitch Ratings set out to determine which payment method ARM borrowers would take when presented with a host of options.

Option ARMs allow borrowers to choose the loan payment they want to make during the start period, usually the first five years of the loan. The choices were the 30-year self-amortizing rate, the 15-year self-amortizing rate (a higher monthly cost than the 30-year rate), an interest-only payment (a lower monthly cost) or a payment which did not actually cover all interest costs (an extremely lower cost relative to the 30-year payment).

So, what did borrowers actually do? The study found that 94 percent of option ARM borrowers made the minimum payment.

This is where logic, common sense and reality diverge. I agree in some sense with Professor Guttentag — his logic is good. The way people frequently behave financially is not, however.

I have no hope that large numbers of ARM borrowers will make bigger monthly payments. Why? The whole idea of an ARM is to originate financing for people who would borrow less if they could only obtain fixed-rate loans. Monthly costs are a huge issue for most ARM borrowers, and for the most part I do not see bigger voluntary payments in their future.

Instead, I view ARMs as a way for lenders to transfer the possibility of inflation to borrowers. I see rising inflation — and higher borrowing costs — as inevitable. Say as inevitable as the urge to pay as little per month as possible.

Peter G. Miller is syndicated to more than 100 newspapers and operates the real estate news site, OurBroker.com.

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