With rates rising since early May of this year, homeowners should take a long hard look before committing to an adjustable rate mortgage, or ARM, as we like to call them in the mortgage business. An ARM can be a great tool that can save you money, but it can also be a dangerous product that can put you in financial distress.
ARMs come is various sizes, and usually a 3/1, 5/1, 7/1 or 10/1 ARM are the most common. What this means is the mortgage is spread over 30 years (like a 30-year fixed rate), but the rate is only fixed for 3, 5, 7, or 10 years respectively. (The shorter the term, the lower the start rate.) What happens after the fixed rate ends is that the loan turns into a 1-year adjustable where the rate will adjust once a year based on where rates are at, along with a margin (the banks profit) to give you your rate for the next 12 months.
So for example, if a borrower takes a 5/1 ARM at 3.5 percent, this means that the rate will be 3.5 percent for the first 5 years of the loan. It will then adjust in year 6 and will continue to adjust once a year until year 30, when the mortgage will be paid off. The danger is that this ARM has adjustment caps of 5/2/5. This means 5 percent the first adjustment max over the start rate, 2 percent every year after that, and a 5 percent max lifetime cap over the start rate. So if the 3.5 percent start rate goes up 3 percent in year 6 to 6.5 percent, then the max the rate can go up to in any given year is to 8.5 percent because the max lifetime cap is 5 percent over the start rate of 3.5 percent.
The mortgage caps are the same for the 5, 7, and 10/1 arm of 5/2/5 but are 2/2/5 for the 3/1 arm, which means that the first adjustment cannot be more than 2 percent over the start rate, and every year after that cannot be more that 2 percent from the previous year and the max lifetime cap is 5 percent over the start rate.
On a $200,000 loan, the payment at 3.5 precent is $898.09. Should it go up 3 percent in the first adjustment, the payment would skyrocket to $1,211.32, an increase of $313.23 per month or $3,758.076 annually. Should it go up again the following year to the maximum rate of 8.5 percent. the payment would go up to $1,437.81 which is another increase of over $200 per month and over $2,400 per year from the previous adjustment.
Instead, if someone just took a 30-year fixed rate at 4.5 percent, the payment would be $1,013.37, which is $115.28 more than the 5-year ARM rate of 3.5 percent, but the borrower would never have to worry about their rate ever adjusting.
When does an ARM make sense? In my opinion, and ARM makes sense for borrowers that are buying or refinancing a home that they know they will only be in for a limited amount of time. For example, if a first-time homebuyer is buying a one-bedroom condo they feel will only suit them for 5 to 6 years, then taking a 7/1 ARM would be wise for them because they are planning on selling and paying off the ARM prior to the adjustment period. This will allow the homeowners to save money by paying less than the 30-year fixed rate and not have to risk the adjustment because they will be selling prior to the adjustment period.
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