Flexing the ARMs
In the mortgage industry, there are some dirty words. Aside from the more obvious ones like "denied" and "dead deal" are some that are more industry jargon than well understood concepts. When speaking with a consumer, many lenders fear the mention of these dirty words might cause borrowers to look elsewhere, so many times the words are never spoken. One of these dirty words is "points" and I just did a write-up that hopefully helps clean that one up. Another word amongst the dirtiest to many borrowers is "ARM".
I know, I know, ARMs are the devil - the sole reason for the mortgage market meltdown just a few years ago - but hear me out. Unlike that ex- that just texted you a hello a couple months after your tenth break-up, ARMs really have changed! They're more stable, safer, and offer a ton of benefit to the right borrower. Who is the right borrower? Well, I'll get to that in a minute, but let's just say it's a lot more people than you might think.
A few years ago, ARMs were a big part of the wild west that was the mortgage industry. Lenders could offer ARMs that were fixed for just 2 years, but were strapped with prepayment penalties of 3 years - this meant that when an ARM adjusted upward, a homeowner was forced to either pay a grossly inflated payment, or to pay a ridiculous sum to refinance (or, even worse, sell their home). That nonsense is a thing of the past. There are no more prepayment penalties that outlast an ARMs fixed term, and there are no unstable features attached to today's ARMs like 40-50 year amortization plans, or negative amortization possibilities. Today, ARMs are the good guys.
So what is an ARM?
Simply put, it's an acronym for Adjustable Rate Mortgage. ARMs are usually seen written as 3/1, 5/1, 7/1, or 10/1 ARMs - the first number indicative of how long the loan has a fixed rate period, and the second number indicating how often the ARM's rate can adjust.
So a 10/1 ARM is a loan amortized over 30 years, but it's fixed for the first 10 years before it begins to adjust. It can then adjust every 1 year after, until it's paid off at year 30. Usually the shorter the fixed rate term, the lower the interest rate. So interest on a 5/1 ARM is usually lower than a 10/1 ARM, and both always have a lower rate than a 30 year fixed rate mortgage.
Who should use an ARM mortgage?
In a recent study it was shown that the average buyer of a single family residence stays in that home for 13 years. With a 10/1 ARM as an option, ARMs aren't a bad idea for the average home buyer. The 3 extra years, even if rates rise, would follow at least 10 years of savings. While ARMs are a good option for the average home buyer, they're a GREAT option for certain situations:
Short term ownership
If a buyer knows they will not have a property longer than 10 years, there is NO reason to have a 30 year fixed rate. On average, a 10/1 ARM offers an interest rate of about .25 lower than a 30 year fixed rate. That means over the first 10 years of a $300,000 mortgage, someone with a 10/1 ARM would save $5,000 over someone that chooses a 30 year fixed rate. With shorter term loans and the use of a 7/1 or 5/1 ARM these savings increase drastically.
Borrowers with future earning potential
Ever hear of those wonderful "doctor loans" where doctors can obtain 100% financing with no PMI? Yep, most of these are ARM loans, based on the fact that doctors recently out of school have large long term earning potential. Borrowers can use an ARM to get a lower payment now to fit their current income, and as their earnings increase, they can afford the mortgage payments IF their loan adjusts in the future. IF the loan doesn't adjust (or better, adjusts downward), they can just continue to enjoy the savings.
Investors can find creative ways to take the interest savings offered by an ARM and earn interest on it, increasing their portfolio or perhaps injecting a business with liquidity. One of my most financially savvy clients has repeatedly borrowed against his home with ARM loans to grow his business and income, and then pay off the ARM before it even comes close to it's adjustment date.
FHA offers ARMs with an added benefit to the lower initial interest rate. FHA ARMs, once they hit their adjustment period, can adjust a maximum of 1% each year. This is great for first time buyers who need to use FHA to finance their home, and likely won't be in that home much longer than 5-7 years.
Who shouldn't use ARMs
Wait, didn't I say investors should use ARMs? Well yes, but those investing heavily in real estate could get quite a shock if the payments on all their properties adjusted at once! Real estate investors with the ultimate goal of free & clear properties that come with a monthly rent check should stick to short-term fixed rate loans to make that dream a reality.
Long term borrowers
Found that forever home? Stick with a fixed rate, unless you can afford payment bumps along the way. After the initial fixed rate period is over, ARMs can fluctuate annually (some fluctuate monthly) and if you can barely afford the fixed rate payment, you can get in trouble if you see a big bump.
Those with tight finances
ARMs should never be used to qualify for 'more house'. If you can't afford a home with a fixed rate loan, you can't afford the home with an ARM, either, despite what your lender may tell you. ARMs should be a financial vehicle and part of a financial plan, not a way to get into a house with the hopes you can improve financially before the adjustment period rolls around. ARMs are for people with plans, not hopes.
Some important things to know about ARMs
How ARMs adjust
ARMs are usually tied to a financial index, and a lender offers loans based on this index, plus a margin. After the fixed rate period of an ARM ends, the rate becomes the index plus the margin. It's important to know what index & margin your ARM is based on, as there are several out there. One of the more common is the LIBOR index.
Is there a limit to how much an ARM can adjust?
Yes. ARMs can't just keep growing, and growing. Generally, for FHA loans there is a lifetime cap of 5% higher than the start rate (remember, FHA can only increase 1% per year though) and conventional loans have a normal cap of 5-6% over the start rate. Many times, there are safety caps in place to prevent large increases from happening immediately after a fixed rate period.
Know your caps
As I mentioned above, ARMs have caps. You may get an ARM with 6/2/6 caps, or 2/2/5 caps, or 1/1/5 caps (FHA). What do these numbers mean? Well, the first number is the maximum % your loan can adjust immediately after the fixed rate period comes to an end. The second number is the maximum % the loan can adjust annually thereafter. The final number is the maximum % the loan can ever adjust.
Let's say you have a 5/1 ARM with 2/2/5 caps, and your fixed rate for the first 5 years is 3%. Once that 5 years is up, the maximum the loan can adjust to for year number 6 would be 5% (your initial 3% rate, plus the 2% first adjustment cap). The max it could adjust to the following year would be 7%, and the max it could adjust to the following year would be 8% (your initial 3% rate plus the lifetime cap of 5%). The loan could never adjust higher than the 8% established by the lifetime cap.
The caps, like the ARM's fixed term, is generally a game of risk VS reward. Just as a 5/1 ARM has a lower rate than a 10/1 ARM, a loan with caps of 6/2/6 will likely have a lower initial interest rate than a loan with caps of 2/2/5. The higher the risk, the higher the reward (a lower initial rate/payment). For long term planning, it's a good idea to use an ARM with more conservative caps. If your plan includes getting rid of the loan before the fixed rate period ends, you can see some additional savings by getting a loan with higher initial caps.
ARMs are a tremendous tool, allowing financially savvy buyers to save a TON of interest. Yes, there's risk, but for a borrower that knows what they're doing, has a plan, and has an experienced mortgage loan officer as a guide, an ARM can play a big role in wealth building and obtaining a mortgage loan that best fits your financial plans.
Have questions on ARM loans or any of the other dirty words in the mortgage industry? Feel free to give me a call at 484.680.4852 or get an instant answer from an expert by clicking here.