Subscribe to this BlogThe case for ARMs
Adjustable-rate mortgages have gotten a pretty bad rap since the housing market tanked a few years ago. After all, the over-availability of ARMs undeniably contributed to the housing bubble and following foreclosure wave. So readers of my recent piece in MONEY’s November issue, “Is it Time to Dump Your ARM?,” might have been surprised to see a recommendation that some homeowners refinancing out of one ARM should refinance into another one.
That’s because despite their flaws, hybrid ARMs, which start out with a fixed-rate period and then adjust on a recurring basis when that period is up, still represent a smart choice for educated borrowers who understand their risks. Yes, many borrowers got hoodwinked into ARMs that cost them their homes, but thousands of homeowners have also benefited from the savings provided by properly used ARMs. The mortgage gurus over at HSH Associates have written at length on this topic, in an interesting recent piece that argues that ARMs are “neither evil nor toxic.”
The ideal ARM borrower will have a fixed time horizon (no more than a year or so beyond the fixed-rate portion of their loan) and the wherewithal, both financially and emotionally, to absorb the higher payments that could come if the rate readjusts upward. And with rates near their nadir, it’s unlikely they’ll go much further down, especially when the economy starts to recover.
Still, with advertised rates for 5/1 jumbo ARMs at around 4.5%, you could save more than $450 a month on a $500,000 loan right now by refinancing into an ARM instead of a fixed-rate mortgage. Most 5/1 ARMs have a cap in the first adjustment year of 5 percentage points, meaning that in a worst-case scenario, your mortgage could jump to around 9.5%. That's an ugly rate, but remember this is the worst possible case. And if you banked half the money you saved each month by choosing an ARM instead of a fixed-rate mortgage, you'd have enough funds to cover the added payments for almost a year until you moved or refinanced.
To be sure, ARMs aren’t the answer for all borrowers, and they’re certainly not the right product for borrowers who can’t afford a house without a low teaser rate. But neither should they be dismissed out of hand. For a primer on how ARMs work and the issues faced by borrowers, check out the Federal Reserve’s Consumer Handbook on Adjustable-Rate Mortgages.
What the article doesn't explain is that those savvy borrowers who have done well with ARM's were disciplined borrowers who could afford the full P&I payment to begin with. The cushion, by saving that say $450 or investing it wisely can be used as a backup in case of job loss or something of that nature. More or less, the moral is that the normal P&I payment should be easily affordable to the borrower. Brokers and lenders should FULL DOC these loans and ask for more. They are good loans when used correctly.
I will take the cold over hurricanes, ravaging wildfires, tornados, drought, or having a Republican led government anyday. At least my house is still there in the spring.
Dan, Buffalo is an extremelly cheap city to live in when compared to tier 1 cities like San Jose. The salaries are much lower in Buffalo than San Jose as well. $500K for a house in San Jose is probably on the lower end. In the DC market, $400K is at the entry-level point. I'm sure that $500K in San Jose is more like $150K in Buffalo. But as one poster pointed out, why would anyone move from San Jose to Buffalo. I'd rather take plentiful jobs in a tier 1 city versus the brutal cold and lack of diverse employers (as in Buffalo) anyday. Every market is different, it helps to do your research first!
Jen, San Jose.. I just looked in the Buffalo Home Finder. Here is what $500,000 gets you: 4000sq feet.. 3 car attached garage… 9' ceilings… 4 bdrm… 3.5 baths… granite, tile, cherry floors throughout…. built in stainless appliances… whirpool bath in master bedroom… walk-in closets in every bedroom. If thats not what you get in San Jose, you are getting SERIOUSLY ripped off. Think about moving.
In October 2005 we refinanced into a 3/1 ARM at 5.5% and took cash out. We never expected to be in the house after the 3 year period but now that the market has been hit hard in AZ we find ourselves happy to be in our current house. Upon the first adjustment, the rate went down to 5.25%. This year's rate is 3.5%. As long as inflation stays in check an ARM was not a bad way to go.
Oh and one other thing, how can the current ARMs reset higher, as some of the other posters have assumed? All of the indexes that are used to calculate adjustments are at all-time lows. There are a lot of people with ARMs that are happy they are resetting right now–resetting lower!
All we've ever used is 5/1 ARMs to purchase homes, and they make a lot of sense. We also put 20% cash down, which should be a requirement to begin with and which provides a lot of discipline in that you know you aren't getting over your head, and if there is a 10% or worse market correction you probably still are not underwater. Obviously with an ARM, if interest rates start to rise it will probably make sense to refinance into a fixed rate product, however, the savings afforded by an adjustable rate product and the likelihood that we are not going to stay in our homes for 30 years makes the 30 year loan sort of overkill for the average homeowner. The best loans actually are calculated with 20 or even 15 year amortizations. That way you are paying down a lot faster, and if you bought your home at a good price, theoretically that should mean it will be easy to refinance at any time in the 5 years well ahead of any potential drastic rate increase.
Who in their right mind needs a house thats $500,000 anyways? Stop wasting money to keep up with the Joneses. That will keep the economy in better shape then being stupid with your finances.
In October of 2004 we took a 3/1 ARM at 5%… The rate didn't change on the 4th year anniversary, and actually dropped to 4.85 6 months later. In February of this year we refinanced to a fixed rate of 4.75%. In our case it worked out great. We originally planned to stay here a few years and of course… that changed. I think the difference is that we went into the ARM aware of the risk… and we bought a house that was below market value as well selling for less than half of the amount the bank offered to loan us. At the end of the day, the responsibility is with the borrower…ALWAYS.
This sounds like a real high-wire act to me; it's hard to make predictions, especially about the future. Still, I'm glad to see that the ARMs worked out so well for the other posters.
The peak year for HARM loans issuance was 2007, so the 3 to 5 year resets for those loans will just begin next year, and they will continue until 2012. The lenders expect a tidal wave of new defaults as the rates explode to higher levels than borrowers are now paying. Hold on to yer hats, boys; it'll be a rough ride.
A five year arm can save you at least a point over a 30 year fixed. In five to seven years you will likely see a full credit cycle; meaning rates may peak and revert before you have to refinance. Another key reason to look at refinancing now is appraisal risk. If houses continue to deflate you may not get the loan regardless of rate. Hopefully, house prices will trough and recover over the next 5-7 years as well. If not, as this article suggests, you need to be prepared to py the higher rate.
This article mentions the very problem with ARM loans, though it glosses over it blithely – that after the interest rate resets, the borrower will likely have to refinance or sell the house. The assumption that refinancing or selling would not present an obstacle was one of the very predicates on which the current housing bust was built. If a borrower's strategy in purchasing a home relies on drastically altering the terms of the loan within a few years (a decision not entirely within the borrower's own control), then the loan is fraught with risk. For a relative handful of financially erudite (and wealthy) borrowers this tactic might work well, but for most this approach could well prove to be another financial siren song.
A comment on the numbers. Sure, at the outset one could save about $450/month by using an ARM rather than an FRM (fixed rate mortgage). On a loan of $500,000 and assuming a fixed mortgage rate of about 6%, monthly payments would be $2997.75 as opposed to $2533.43 for the 4.5% ARM, exclusive of taxes and insurance. After 5 years, though, the payments on the ARM loan would reset. The worst case scenario mentioned would have the monthly payments jump from $2533.43 up to $3982.22. Compare that number with the FRM payments of $2997.75, which would remain the same. The ARM loan now costs $1000 more per month. Even at a more modest reset rate of 7.5%, the payments will jump up to $3368.25, an increase of more than $800 per month that will quickly eat into the prior $450 monthly savings. It should also be noted that most non-exotic hybrid ARM's have a 2/28 or 3/27 structure, rather than a 5/25 structure, which is usually applied to more exotic instruments such as I/O's and option payment loans.
In addition, we should consider what the borrower achieves by employing this strategy. After 5 years of payments, the ARM borrower would have built up approximately $45,000 of equity in the house. However, upon refinancing or selling the house, the borrower will have to pay refinancing or closing fees. This will cut into the borrower's retained equity. Of course, if the borrower cannot sell or refi right away, he/she will have to make the higher payments until the property can successfully be refi-ed or sold. Those elevated payments will eat into the money saved during the introductory period. True, the borrower will benefit if the property appreciates in value, but the borrower will lose if the property depreciates. Anybody heard the term "underwater" lately?
As acknowledged, these instruments may be suitable for a few erudite and wealthy purchasers (who would not be likely to borrow for such a purchase anyway), but not for the vast majority of other borrowers. It is imprudent to gamble with money one does not have.
Good article. I financed a home purchase in 2004 with a 5/1 ARM and an initial rate of 4.5% (9.5% cap). I would have paid around 5.5% for a 15 year or 6% for a 30 year fixed rate loan. The ARM reset last month to an even lower rate of 3.2%. I know that I am lucky right now – but I know too that I can afford a 9.5% rate on my outstanding balance. Other assumptions and actions.
1) I assumed that I will move within 5-10 years anyway.
2) I was able to make a substantial down payment when I bought the house.
3) I paid additional monthly principle with the savings I got from the lower interest rates.
4) I made additional principle payments when ever possible (e.g tax refunds, bonus).
Several years agao, I had to take a significant pay cut and thought I might lose my job. I jumped into a 5/1 ARM to reduce my payments and bring the loan back to 30 yrs from 12 yrs reamaining. I made payments in the old amount and significantly reduced my exposure even though the ARM could go up to 12.5% which was 4% higher than my old mortgage. My payments just changed and are 15% of my original mortgage. It worked for me since I was disciplined and recognized the purpose as reducing my payments as opposed to buying something with payments being based on best case scenarioes.
My ARM actually saved me money. I took out a 5/1 Jumbo ARM 5 years ago on the current house I am living in. At the time the fixed rate was 6 percent. We just went thru our first adjusment on the loan, and since interest rates are so low our rate actually went down and is now at 4 percent and our mortgage payment went down by $250, I am willing to keep the ARM for the next 12 months until our next adjustment to see what the rates are like then, if they are still low, will probably stick with it.
Hi Dan, ARMs did get a bad rap and somewhat deserved. It is not the product itself but rather the use of the produt. If the housing market had not collapsed we may not even be having this discussion. Interest only took an even a harder rap. Did you know that on an interest only arm you can pay down the balance with the money you saved and the lown will recast itself with a lower payment. There are certain limits on the amount allowed to pay down and time frames but for the right borrower in the right property given the right time frame for ownership this is an excellent savings strategy. I do work for a lender so I am a little biased but . . .