So here’s where the rubber meets the road. Should you get an ARM? You may be thinking ARMs are a ridiculous idea. Why take the risk of making your payment unaffordable one day and losing your home just to save a few bucks at the beginning? I’ll tell you why it’s a smart move sometimes.
What are your plans for the future?
Are you retiring soon?
Do you plan to start a family?
Are you or your spouse currently going to college or grad school and expecting to earn more money in the future?
There is an endless amount of reasons why the home you’re buying may not be a home you plan to stay in indefinitely. And if you plan on moving in let’s say five to seven years for example, why do you need a 30 year fixed rate?
Think about a fixed rate as something you typically have to pay more for. If you plan on moving out of your property in several years, why are you paying more for a long term fixed rate you have no intention of using?
You might be saying, “Yeah Ed…we may plan to move, but you know what they say about best laid plans”. To that I say sure. Life happens, and it often doesn’t happen the way we planned. So get an idea of what impact a delay in your plans would have on your loan.
Let’s say for example you take out a $250,000 mortgage to buy a home, and you intend to sell the property in five years. In an effort to get a lower rate you opt to go with the VA 5/1 Hybrid ARM with an intro rate of 3.5%. But things don’t go the way you planned and you end up in the house two years longer than you expected. This is what that may look like (keep in mind these payments do not include property taxes or insurance).
Payment for years one though five - $1,122
Balance at the end of five years - $224,242
Year six interest rate 5.5% (assuming it increases the maximum allowable by VA caps)
Payment for year six - $1,377 ($255 higher than intro payment)
Balance at the end of year six - $219,943
Year seven interest rate 7.5% (assuming it increases the maximum amount allowable)
Payment for year seven - $1,648 ($526 higher than intro payment)
Balance at the end of year seven - $216,538
The easiest way to give yourself some breathing room with ARMs in case your plans change is to make extra principal payments during the intro period. In keeping with the example above, let’s explore what that would look like if you paid an extra $150 a month towards the principal for the first five years.
Payment for years one though five - $1,272
Balance at the end of five years - $214,422
Year six interest rate 5.5% (assuming it increases the maximum allowable by VA caps)
Payment for year six - $1,316 ($44 higher than intro payment with extra principal)
Balance at the end of year six - $210,311
Year seven interest rate 7.5% (assuming it increases the maximum amount allowable)
Payment for year seven - $1,576 ($304 higher than intro payment with extra principal)
Balance at the end of year seven - $207,055
You may look at this and become filled with fear and anxiety. If that’s the case this may not be a favorable option for you. Conversely, if you look at this and think “oh…that’s not that bad at all” then an ARM may be something you want to explore. Understand that I’m using a worst case scenario. For the most part interest rates have held steady between the 3s to 5s for the better part of the last ten years.
I’ve been in this industry for over a decade and I’ve yet to see a rate environment that caused a homeowner’s annual rate adjustments to consistently hit the caps. Despite all the hoopla around ARMs, people who have them have seen only nominal adjustments on their rates over the last decade.
Remember the lifetime caps are five or six percent depending on the length of your fixed period. So in the example I used above the rate can’t get much higher. Also note that as long as you’ve made timely mortgage payments you can always refinance a VA mortgage loan to a fixed rate loan. So if your plans to move change to you staying in the home indefinitely, you won’t be forced to ride the market rate rollercoaster in perpetuity.
With that being said, the most important thing here is the pricing. It makes no sense to take an ARM loan if the rate is equal to or only slightly less than the fixed interest rate you would qualify for. ARMs are a risk for the homeowner. You are opening yourself up to the possibility of significant increases in the rate of interest you will pay, and thus the affordability of your monthly payment.
When you take a risk there should be a subsequent reward. That reward is an intro rate significantly lower than the available fixed rate. In the absence of that discount in pricing, there’s no motivation for getting an ARM.
My intent is not to convince you to get an ARM. Rather my intent is to help you understand the benefit of ARMs, and inspire you to ask yourself the questions that will help you identify if this may be the right loan product for you.
Now that you understand how ARMs work you’re probably wondering what the best practices are for shopping interest rates. For more information about that be sure to watch my video “how to rate shop” were I’ll be breaking that down in detail and showing you exactly what to look for.
