With the mortgage meltdown still fresh in our minds, it seems unlikely that anyone would take an adjustable-rate mortgage (ARM). Yet ARM loans are back, and yes, homebuyers are opting to take them.
Why ARMs are a Bad Idea
ARMs are a bad idea for the homebuyer right now. Here’s why:
1. Rates are at record low levels.
With fixed mortgage rates currently running at the mid 3.-something level for a 30-year loan, and the high 2.-something range for 15-year mortgages, we’re looking at the lowest home loan rates since records have been kept, and even all the way back to and including the Great Depression.
In this type of environment, locking in those rates for 15 to 30 years should be done on instinct. If you like a 30-year loan at 3.5%, you will never pay more than that no matter what happens over the next three decades. Few financial transactions in life are either as sweet or as certain. You could be paying 3.5% even if mortgage rates return to their historic norm of 6-7%.
There may be an anticipation that rates can fall even further from where they are now, but that’s pure speculation. We should never bet against trends that are of historic proportions, and that’s where current mortgage rates are right now.
2. Rates have no where to go but up.
Since rates are so low already, if there is a move in any direction it will almost certainly be higher. It is possible that they could move down fractionally, but the likelihood of another full point drop is extremely low.
On the other hand, the possibility of an increase of one point – or several – from these historic low rates is far more likely. With fixed rates hovering around 3.5% on 30-year loans, there isn’t much room on the downside. But since those rates are currently at only about half of the historic norm for fixed-rate mortgages, there’s plenty of room to go on the upside.
The nightmare scenario of course would be for mortgage rates to challenge their all-time high of greater than 16% during the early 1980s. I’m not predicting this outcome, only attempting to provide some historical perspective. If we say that the lowest mortgage rates could go is zero, and the highest is 16%, then we are far closer to zero at the current 3.5% than we are to the all-time high. And interest rates can never go to zero because investors require a return on their money in order to fund mortgages.
If you had to bet where interest rates will be five years from now, you’d have to predict they’ll be higher based on mathematics alone.
How Your 2.5% ARM Mortgage Can Become 7.5%
People are drawn to ARM mortgages by the temporary relief that they offer from fixed-rate loans. With 30-year fixed-rate loans at around 3.5%, you can take a 5/1 ARM for around 2.5% – a full percentage point less. What’s more, you’ll have the benefit of the lower rate for the first five years of the loan. So far, so good.
But the problem with ARM loans is that all the good news is at the beginning. Sure, you will be better off during the initial five-year fixed rate period, but after that, the loan converts to a one-year adjustable. That is to say that the rate will adjust each and every year after the five-year fixed rate period.
ARM loans come with what are called “caps.” These are predetermined limits on how high the interest rate can go, and even when the limits apply. A 5/1 ARM loan typically has a 5/2/5 cap structure. What that means is that the interest rate can increase by . . . .
- As much as 5 percentage points in the first adjustment, which applies at the beginning of year number six of the mortgage.
- No more than 2% for any subsequent rate change.
- An increase of not more than 5 percentage points over the life of the loan.
Were interest rates to take off between now and the time that the fixed rate portion of your loan expires, your 2.5% mortgage could turn into a 7.5% loan overnight.
The Usual Arguments in Favor of ARM Loans May Be Wishful Thinking
People who take ARM loans usually do so because they intend to sell the home within the five-year fixed rate period of the loan. If you can be 100% certain that this would happen, then taking an ARM loan would absolutely be the right course of action.
The problem is we’re never guaranteed of anything, especially when talking about five years into the future.
All kinds of variables can apply when it comes to future events. An expected promotion may not materialize. A divorce could split a household. The housing market could freeze up making it impossible to sell the house to get out from under the mortgage.
It’s worth noting as well as that rising interest rates often occur at the same time as employment and economic troubles, and are a major reason that would cause the housing market to freeze.
Putting Your Home at an Unnecessary Risk
What an ARM loan does is put your home at risk. A five point increase in your mortgage, happening at a time when you’re unable to sell your house, is a recipe for foreclosure. Your interest rate will virtually triple, making it dramatically more difficult for you to make the monthly payment. You will have put your house at risk for the benefit of a five-year break in your mortgage rate in the early years of the loan.
The problem with ARM loans is that they don’t give you much flexibility in the event that the future doesn’t play out the way you hope. Because interest rates can increase so significantly, and in such a short amount of time, you’ll have little reaction time to get out from under them.
What are your thoughts on ARM loans? Would you take one to save 1% on your mortgage rate for five years? Leave a comment!
I mostly agree but point no.2 isn’t quite truth. Rates are LIKELY to go up, but no one can guarantee that. Bond managers have been saying rates are going to go up quarter after quarter for over a year now but they (rates) still haven’t. Last I recall Bernake stated he is going to try to keep rates low. Instead of saying rates can’t go lower or must rise I’d emphasize there is little upside to get a variable ARM over a fixed rate. The downside far exceeds the benefit. I think its also important to know that you can still refinance fixed rates if they go significantly lower. But if you have an arm that adjusts up and rates increase you’re probably stuck.