Should ARMs Be More Popular?

If you want to know why the Federal Reserve has been so uncertain about raising interest rates you don’t need to look much further than Fannie Mae and Freddie Mac. These are among the largest mortgage holders in the world and even they can’t agree where the market is heading.

According to Freddie Mac, “the nation’s housing markets are getting back on track. In June, 45 of the 50 states and 95 of the 100 metros were showing an improving three month trend.”

However, Fannie Mae explains that while the housing market is improving, “second quarter economic growth was weaker than expected, and its composition presents a less optimistic outlook for the rest of the year.”

Such projections, plus the Fed’s constant back-and-forth, make interest-rate predictions uncertain and the bi-product of such uncertainty is beginning to show up in mortgage originations.

Data from EllieMae shows that in July ARMs represented 5.5 percent of all new loans — that’s down from 6.5 percent a year earlier.

The reason to get an ARM is because you can lock-in very low rates for five years. For instance, according to Freddie Mac at the start of September prime borrowers could get 30-year financing at 3.89 percent while a 5/1 ARM was priced at 2.93 percent.

A growing number of people, apparently, see increasing risk in the marketplace and for that reason are staying away from ARMs. Fair enough, but there is also risk with fixed-rate financing, something not often discussed.

In today’s market a 5/1 ARM is an attractive financial option and yet not too many borrowers are interested. The reason, most likely, is a fear of higher rates down the road, a not unreasonable worry but one which has been made far more manageable in recent years.

The reason higher ARM costs are less worrisome relates to three issues.

First, the typical loan is only outstanding six years. If you have a low fixed-rate for five years and likely will only keep the financing for one additional year then the risk of payment shock is minimized.

Second, ARMs have caps which limit annual rate hikes.

Third, after five-years ARM have a lower balance than when the loan was originated.

Imagine that Green wants a $200,000 mortgage and can get a 30-year fixed-rate loan at 3.89 percent or a 5/1 ARM with a 2.93 percent start rate.

The monthly cost for principal and interest is $942.19 for the 30-year loan versus $841.05 for the ARM. That’s a difference of $101.14 per month or $6,068 over five years.

After five-years the loan balance for the fixed-rate loan has been reduced to $180,572 while the ARM with the lower rate is down to $177,748. Again the ARM borrower is ahead, this time by $2,824.

Now let’s look at two alternative ideas.

In the first case the ARM borrower makes an extra principal payment every month by simply paying $942.19, just like the fixed-rate borrower. Now, after five years, the ARM borrower has an outstanding balance of $171,217. That’s $9,355 less debt than the fixed-rate loan, one way to measure the fixed-rate borrower’s risk.

In the second case let’s say that in the sixth year the ARM’s interest rate rises by a full 2 percent, the maximum allowed. We now have a 25-year mortgage at 4.93 percent with a principal balance of $171,217 and a monthly payment for principal and interest of $998.92.

That’s $56.73 more per month for the ARM borrower — IF the interest rate goes up to the maximum allowable annual amount.

By year seven there’s a 50-50 change that the ARM borrower will have moved or refinanced and when he or she does less will be owed and that means the borrower will pay a lot less to the lender at closing.

Just like the Fed, we don’t know where interest rates are going and reasonable people can argue and debate the issue. However, for many borrowers — a lot more than 6.5 percent — an ARM is not an illogical financing choice given today’s rates and the likelihood that the loan will not be outstanding for much more than six years, if that long.

We usually think of ARMs as more risky than fixed-rate financing because it’s possible for monthly costs to rise. At the same time, it should not be thought that fixed-rate loans are without risk, It’s possible that rates could remain depressed as they have been for the past few years in which case an ARM might be a good financing option, an idea more borrowers might want to consider.

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