The following article was originally published on Aaron Lending, LLC’s website. We decided to share it with you because it’s full of helpful information about adjustable rate mortgages as well as several real world scenarios.
I will admit that as a borrower, Adjustable Rate Mortgages (ARMs) always scared me a little. I didn’t like the uncertainty that came with a rate, and thus a payment, that would change in the future in unknown ways.
Good or bad.
Of course sharing that risk is why a Lender is willing to give you a lower initial rate for an Adjustable Rate Mortgage.
Choosing a Fixed Rate Mortgage might be a better fit for people with a more fiscally conservative nature. But that doesn’t mean there’s no place for ARMs. There are some solid reasons for looking at ARMs, reasons that increase as rates continue to rise and new ARM options become available.
Let’s take a look at one ARM option specifically, the 7/1 ARM.
The 7/1 ARM is an Adjustable Rate Mortgage with a lower starter rate that the borrower will have for the first seven years of the loan. After the first seven years (84 months) have passed the loan will adjust once every year.
Here’s a comparison of the 7/1 ARM to a 30-year Conventional Fixed Rate Mortgage on a $300,000 loan at 80% Loan To Value (meaning a sales price or appraised value of $375,000) and 740 FICO.
The following adjustments apply to the 7/1 ARM: Margin – 2.250, Index – 1.828, 7/1 Caps 5/2/5.
This is NOT a quote. It doesn’t include any taxes, insurance, fees or anything else. We’re talking straight P&I here – Principal and Interest.
A 30 year Conventional Fixed Rate Mortgage at 4.375% (APR of 4.414%) would be $1497.86 per month for P&I.
7/1 ARM at 3.875% (APR of 4.020%) would be $1,410.71 per month P&I
The difference between the two loans would be $87.82 per month and $7,376.88 over the first 84 months of the loan.
The $87.82 savings could be allocated to other investments like retirement accounts and/or college savings.
Other benefits of the 7/1 ARM in the first 84 months include the additional savings on interest paid. Plus after 84 months you will have paid off more of the principal and have a greater equity position in the home. So if you sell the property you get more money back or if you refinance you are refinancing a smaller loan amount.
But what happens after 84 months?
As I mentioned you could sell the home, refinance the home or you could ride out the adjustments. There is a cap on the increase so let’s take a look at the worst case scenario of hitting that cap.
In this example the rate cap at the first adjustment and the lifetime cap are 5%. Let’s assume the worst. Let’s assume a jump from the 3.875% to 8.875% with your monthly payment jumping from $1,410.71 to $2,190.54. That’s an increase of $779.83 and a difference of $692.68 over the 30 Year Fixed Rate initially described.
At this new payment it means that the $7,376.88 savings incurred in the initial 84 months of the ARM v. Fixed Rate will be gone in 10 months. After month 94 the ARM would be costing you more than the 30 year fixed rate mortgage would have.
But that’s the worst case scenario. The rates could go up or they could go down. Guess what happened to all of the ARMs that adjusted between 2008 – 2015? They all went down. Only the subprime adjustable loans ended up going up.
For more information about mortgages and the home buying process, take a look at our blog’s For Buyers section.