The New ARM Debateby Tim Manni
Over the next several months to a year, rates are expected to head in one direction: up. If you’re a borrower with an adjustable-rate mortgage (ARM) you’ve enjoyed reset rates recently as low as 3%. According to last week’s Market Trends Newsletter, the initial fixed interest rate for a Hybrid 5/1 ARM ticked one basis point higher to finish the survey week at 4.58%.
Does the forecast for rising rates signify that it’s time for ARM borrowers to refinance into a fixed-rate loan? Not exactly.
Due to the Fed’s mortgage-backed securities purchase program, fixed rates themselves have dropped to levels unseen in 50 years. While 30-year fixed rates have remained pretty steady over the last few weeks, and although we predict that rates will increase over the next few months due to Fed’s upcoming absence from the market, fixed rates should still remain quite favorable.
That being said, there are significant savings to be had with an ARM — both for first-time buyers and refinancers — if those savings are utilized properly:
A borrower buying a $375,000 home with a 20% downpayment would have a $300,000 mortgage. At recent rates, and compared against a traditional 30-year FRM, a 5/1 ARM would produce a savings of about $138 per month and would see a borrower spend over $11,000 less in interest over the 60-month fixed-rate period.
At the end of that period, the remaining balance of the loan would have shrunk by $3,000 more than the 30-year FRMs (that is, the borrower would have $3,000 more equity). This could be improved to a more significant degree by using the differential in payment ($138) as a prepayment for the ARM, which would produce another $9,000 in equity over that fixed-rate period.
Of course, selecting an ARM isn’t without risk; rates could rise in the future, eroding some of the accumulated savings. However, if a borrower banked the $138 per month for the entire period, they would have built an $8200 “mortgage subsidy account” to be used to ameliorate the effects of a rise in monthly payment after the 60th month. In the prepayment arrangement, they would have a $12,000 smaller loan balance, which would serve to partially offset the rise in monthly payment caused by a higher loan reset rate.
The same strategy can be applied to borrowers who are going to refi into an ARM, a practice most common among “jumbo” mortgage borrowers. Socking away the savings you’ve accumulated in a “mortgage subsidy account” can help ameliorate any added costs when the fixed period of your ARM expires.