Buying a Home? Consider using an ARM To Save Lots of Money
Last week, (July 11, 2011) the Wall Street Journal printed an article entitled "A Home is a Lousy Investment". The basic premise was that $1 invested in a home in 1980 would have grown to $2.98 in 2010. That same dollar in the Dow Jones would have grown to $11.49 in 2010. At no point during the 30 year time period would the dollar invested in the home outperform the dollar in the stock market. Does this mean you shouldn't buy a home? NO. But you do need to evaluate your options and make the best decision for yourself.
Adjustable Rate Mortgages (ARM's) have been slammed recently as being one of the causes of the housing collapse. Greed, loose lending standards and unemployment are the causes of the housing collapse. ARMs come with lower interest rates and lower payments than 30 year fixed mortgages. The catch? After a period of time (3-10 years) the interest rate will reset, often causing the payment to increase. Now, with interest rates being what they are, many would argue that a 30 year fixed makes more sense because rates will only go up and you should lock in the low rates, right? Well, maybe it does, but maybe it doesn't.
The average mortgage lasts around 7 years. So, the average person moves or refinances every 7 years. Few people make it 30 years in one mortgage, so why commit to something for that long if there's little chance the extra time will be used. This is one of the reasons that ARMs could be the right mortgage product for many people.
Before you continue reading, please answer the following questions. Am I a person who is unable to be financially disciplined? Am I absolutely risk averse? Do I hate saving money? If the answer to any of these questions is yes, please stop reading. If you like to save money, can tolerate some risk and are financially disciplined, please read on.
For example, borrowing $200,000 in a fixed rate, 30 year term mortgage at 4.625% (today's rate) has a monthly payment of $1,028.28 (P&I). After 5 years $182,658.62 is still owed, resulting in equity of $17,341.38. Total payments to date are $61,696.80. FYI, borrowing money is expensive.
With a 5/1 ARM, the same $200,000 at 2.875% would have a monthly payment of $829.78 or $198.50 per month less. After 5 years, equity would be $22,595.22, a difference of $5,253.84 in favor of the ARM. Total payments would be $49,786.80 a savings of $11,910. Adding increased equity and payment savings puts the ARM ahead at this point by $17,163.84. If you have a better way of saving over $17,000 over 5 years, please let me know.
Additionally, investing the $198.50 per month extra would, at a conservative 6% annual rate of return, earn an additional $2,008.55 over 5 years. Using an ARM would SAVE $19,172.39. To recap, additional equity would be $5,253 and actual cash in hand (invested) would be $13,918.
Ok, so you want to stay in your house more than 5 years. What happens next? The ARM will reset to a new interest rate after 5 years. What the rate will be is anybody's guess, but many ARMs limit increases. For my example, let's say that the increase is limited to 2% per year and 6% over the life of the loan. In year 6, the worst case scenario, the rate will be 4.875%, which is only slightly higher than the original 4.625% of the 30 year fixed rate. Additionally, when the ARM resets, the principal will be based on the current balance, so when the loan resets the new rate 4.875% (assuming worst case scenario) would bring the new monthly payment up to $1,024.21 (amortized over 25 remaining years) which is still $4.07 less than it would have been under a 30 year fixed mortgage and the invested $13,918 would have now grown to $14,777 (assuming no additional contributions). Also, at the end of 6 years, the balance is now $173,680.23.
In the best case scenario, the rate would stay at 2.875% and you could continue to sock away $198.50 per month and everything is working out perfectly.
Clearly, for the 1st 6 years an ARM is going to be a better choice given the assumptions. What about year 7? Again, assuming worst case scenario, the new rate would be 6.875% and the new payment would be about $1,232 per month. In year 8, the balance is now $170,733.65 for the worst possible rate 8.875% bringing the 8th year payment to $1452.81 (amortized over 23 years). At this point, it would probably make sense to refinance into another ARM before the 8th year. Assuming a new 5/1 ARM at a 7% rate amortized over 30 years would drop the payment back to $1135.90. Maybe this is part of the reason the average mortgage only lasts 7 years??
Now, there are a lot of assumptions here, but each is using a worst case scenario. Actual results should, hopefully, be expected to be better. Since 1995, the highest annual average rate for any year was 8.05% for 30 year fixed mortgages.
But wait, there's more. What if, instead, the extra $198.50 was paid into the mortgage instead (you don't trust the stock market)? Making the same assumptions as before, the 5/1 ARM now having the same payment as the 30 year fixed would, after 5 years, result in a balance of $163,979. You now have an additional $18,679 in equity vs. a 30 year fixed mortgage in only 5 years. Adjusting the rate for year 6 to 4.875% makes the new payment actually drops to $766.99/mo. And after that, who cares, because you're going to refinance your much smaller balance anyway.
Either way, investing the $198.50 in the stock market or adding it to your mortgage, the 5/1 ARM saves you money. Personally, I would put it in the stock market because I would hope to get better than a 6% rate of return (10% builds $198.50/mo to $15,500 after 5 years). Even if you spend the extra $198.50 on vacations, cars, burn it in the fireplace, etc, you'll still be happier and better off with a lower mortgage balance in the ARM.
An ARM will outperform a 30 year fixed mortgage in regards to building equity and saving money, if you are financially disciplined and can accept some risk. You should consider all your options, including using an ARM for your next home purchase but please do your homework and consult a professional.
Buying a Home? Consider using an ARM To Save Lots of Money