"ARM vs. Fixed Rate---The Most Important Decision" Many readers and clients of mine have requested that I write about the difference between adjustable rate mortgages (ARM) vs. fixed rate mortgages. Some are Realtors who use my newsletter to hand out to their buyers. Others would simply like a better explanation. ARMs have become enormously popular. Statistics show that, currently, 65% of buyers nationwide choose fixed rate mortgages over ARMs. Last year at this time, ARMs only made up 14% of all mortgage applications. Eighty percent of my business, here in Las Vegas, is ARM vs. fixed. I am sure you have your own opinion why but that will not be the topic of the newsletter. I am going to assume that you are familiar with fixed rate mortgages like 15 Year Fixed and 30 Year Fixed. Therefore, I do not need to describe how they work. However, ARMs are a bit more difficult and require more explaining. An adjustable rate mortgage (ARM) is simply a mortgage where the interest rate is fixed for a certain period of time, then adjusted periodically. The adjusted rate is arrived at by adding a predetermined margin to an agreed-upon index, subject to certain limits called caps. The adjustment can be up or down. For example on a "3/1 ARM", you would be fixed for three years (the 3 in "3/1"), it would then adjust every year (the 1 in "3/1"). So how does it adjust? It adjusts simply based on "index" (at the time of adjustment) + "margin" (which was predetermined when you originally got your loan.) INDEX refers to the different types of indexes that ARMs use. They are LIBOR (London Interbank Offered Rate), which has become very popular, US Treasury Securities, or the Cost of Funds Index (COFI). In most cases, you can choose the index in which you would like your ARM to be tied. The MARGIN is a pre-determined amount (for example 3.250%) that is added to the index value on the adjustment date to arrive at your interest rate. Still with me? Barely, I am sure. OK, so you have a 3/1 ARM that you first purchased on June 27, 2001 with a 5.750% interest rate. That ARM was tied to the LIBOR index and came with a margin of 3.250%. Since you got it at 5.750%, for the past three years, each and every month for 36 months, you paid a fixed rate of 5.750%. You don't need to worry about the index and the margin until the adjustment period begins. It's fixed for three years. However, in June 2004, exactly three years later, it is now going to adjust. Now, remember how the adjustment will occur. It is now "index" + "margin." In the example we are using, this means, "LIBOR index" + "margin of 3.250%." If the LIBOR index is at 2.00 on the adjustment date and your margin is 3.25%, you new rate will be 5.25%. 2.00 + 3.25= 5.25. It actually adjusted down from where you were three years ago. Nearly all adjustable rate mortgages have caps no matter what happens with rates during your term. 5% or 6% is the normal life cap of an ARM while the yearly cap is usually no higher than 2%. This means if you started at 5.75%, the most it could go up in a year, after the fixed period, would be to 7.75% and the most it could adjust up over the life of the loan would be to 10.75% or 11.75%. However, be careful. There are some ARMs with no yearly cap for the first adjustment. In theory, it could go to the life cap immediately, if rates soared that high. Obviously, you can refinance this whenever you want so long as you don't have a prepayment penalty that prevents this from happening. We will discuss prepayment penalties in a future newsletter. A quick note. You hear a lot of agents and mortgage people talking about the LIBOR index. It has become, in my experience, the most popular of the indexes. Some experts say this index has gained this popularity because, since it is a London-based index, it is an international index that reflects the global economic climate. This can make it more appealing for a larger group of international investors, which in some conditions, can make it more competitive. Choosing between a fixed rate or adjustable rate is the single most important decision you make when choosing a mortgage. ARMs usually have lower rates than fixed mortgages. Why? Because if I loan you money for 30 years at a fixed rate of 6.00% and rates go up to 10.000% sometime in the next 30 years, I am in bad shape. I committed to you at 6.00% and now I am getting hurt on my investment. I took a chance and I am now losing. Now let's say I only loan you money for a fixed period of three years and I get to adjust the loan based on market conditions when the three years is over. Well, there is a lot less risk to me. If rates go to 10.000%, I get to adjust your loan to try and catch up. Less risk to the bank means lower rates to you. That's why the rate on 5 Year ARM is less than a 30 Year Fixed, a 3 Year ARM is less than a 5, and a 6mo ARM is less than a 3 Year ARM and a One Month Libor is less than a 6 month. The shorter the term, the lower the risk. See those billboards and ads for 1.25% or 1.95% mortgages?? How long do you think they are fixed for? More on this below. The low initial cost of adjustable-rate mortgages can be very tempting to home buyers, yet they carry a great deal of uncertainty. Fixed-rate mortgages offer rate and payment security, but they can be more expensive. PROS AND CONS OF ARMS AND FIXED ARM advantages --Lower rates and lower payments early on in the loan term. Because lenders can use the lower payment when qualifying borrowers, borrowers can purchase much larger and expensive homes than they could with a fixed rate. --ARMs allow borrowers to take advantage of falling rates without refinancing. Instead of having to pay a whole new set of closing costs and fees, ARM borrowers just sit back and watch their rates fall. --Can help borrowers save and invest more money. Someone who has a payment that's $400 less with an ARM than with a fixed-rate can save that money and possibly earn more off this money in a higher-yielding investment. --Offers a cheap way for borrowers who don't plan on living in one place for very long to buy a house. If you are only going to be in the house a short period of time, you want an ARM. --Gives the borrower more "control" over his mortgage payment. If you borrower $300,000 and the ARM payment is $1500 while the fixed payment is $1800, nothing stops you from sending in that additional savings for principal payments. It just means your monthly commitment is less in case of emergency or some other unforeseen expense. However, you also have to consider the risks of adjustment. ARM disadvantages --Rates and payments can rise significantly over the life of the loan. A 6.000% ARM can eventually end up at 11.000%-12.000% if rates rise. --A borrower's initial low rate will likely adjust to a level higher than the going fixed-rate level in almost every case even if rates in the economy as a whole don't change. That's because ARMs have initial fixed rates that are set artificially low. --The first adjustment can be a whopper because some annual caps don't apply to the initial change. Someone with an annual cap of 2.000% and a lifetime cap of 6.000% could theoretically see the rate shoot from 6.000% to 12.000% in a very short time if rates in the overall economy skyrocket. --As this newsletter is pointing out, ARMs are much more difficult to understand. Some lenders have more flexibility when determining margins, caps, adjustment indexes and other things, so unsophisticated borrowers can easily get taken by unscrupulous mortgage guys and never even know what hit them. --On certain ARMs, called negative amortization loans, payments are set so low (to make the loans even more affordable) they only cover part of the interest due the bank. Any additional amount due gets rolled into the principal balance. This can mean you end up owing MORE than you originally borrowed. Remember 1.25% and 1.95%? They are likely negative amortization loans. Fixed Rate Advantages --Rates and payments remain constant. Even if inflation surges out of control and mortgage rates went to 15 percent, you are happy because you are fixed. --Stability makes budgeting easier. People can manage their money with more certainty because their housing outlays don't ever change. --Simple to understand. Great for first-time buyers who look at you like a deer caught in headlights when you talk about a 5/1 LIBOR ARM with 2/6 caps. Fixed disadvantages --To take advantage of falling rates, fixed rate holders have to refinance. That means a few thousand dollars in closing costs, another trip to the title company's office and several hours spent digging up paycheck stubs, bank statements, etc. --Can be too expensive for some borrowers, especially in high-rate environments or areas where homes are more expensive. "So which way should your client go??" Here are some questions that I use when helping a borrower make the decision.... QUESTION #1: How long do you plan on staying in the home? This is, by far, the most important question any mortgage lender should ask you when making the decision between ARM and Fixed. Five years? 10 years? 30 years? The length of time you will be in the home most determines what program you should choose. If you only plan to be in the home for 5'7 years or less, you should seriously consider an adjustable rate loan. If you intend on staying 15'30 years, a fixed rate mortgage is probably right for you. If you are only going to be living in the house a few years, you'll never be exposed to huge rate adjustments because you'll be moving out before the adjustable rate period begins. Let's say you know you will not be in this house more than five years. There is no reason to pay 6.500% for a 30 year loan, when you could pay 5.500% for a 5-year ARM, since you will not be there past five. You would have paid 1% in additional interest each month for 60 months for the 30 year loan. A substantial savings. Keep in mind, the mortgage lender takes extra risk in committing to a constant interest rate for 15 to 30 years, so they charge you a premium for their risk. If you aren't going to keep your mortgage more than five to seven years, you're probably paying unnecessary interest costs to carry a fixed-rate mortgage. If you are pretty sure that you'll hang onto a property for seven years or less, I recommend you choose the ARM. QUESTION #2: What's the interest rate environment like and where do you think they going ? When rates are relatively high, ARMs make more sense because their lower initial rates allow borrowers to still buy a home. Rates don't stay up forever so when they do fall again the borrowers will have a decent chance of getting even lower payments even if they don't refinance. When rates are relatively low, however, fixed may make more sense. After all, 6.500% percent is a still a great rate to borrow money at for 30 years. This is a common question..."If I THINK rates are going up, shouldn't I lock in on a fixed rate before they go higher?" Yes and no. None of us can predict the future course of interest rates. If we could, we would be making millions investing in bonds and interest-rate futures and options. The Wall Street pros can't make these predictions. Neither can you or I. Your best bet is to go back to Question #1. QUESTION #3: Can you still afford your monthly payment if interest rates rise significantly? If your 5.500% ARM ends up at 8.750%, where will that leave you financially if for some reason you are not able to refinance it any lower. If that kind of jump in your payment means you can no longer afford the house, it may be best to think about the fixed rate. QUESTION #4: How willing and able are you to take on financial risk? Consider an ARM only if you're financially secure enough to handle the jump as described above. You must also be emotionally secure enough to handle volatile rates. Taking an ARM simply because the initially lower interest rates allow you to afford the property you want to buy may not be the wisest of financial decisions. If you are the type of buyer that needs to know exactly what you will be paying each month for the term of the mortgage, a fixed rate mortgage is for you. The fixed rate loan, however, will also have a higher interest rate. If you are willing to take some risk of fluctuations in the interest rate, consider the ARM. QUESTION #5: What are your income expectations? Do you anticipate an increase in your income in the next few years? If you expect a big increase, a ARM may be best for you since the potentially larger payment won't matter as much with your new income. QUESTION #6: When will you refi to get rid of your mortgage insurance or your second mortgage? If applicable. If you don't put 20% down on the purchase of your home you are very likely to have PMI (private mortgage insurance) or a second mortgage, which usually has a higher interest rate than your first mortgage. When you have 20% equity in your home, you can likely get the PMI or second mortgage removed by refinancing into one loan at a presumably lower overall rate. In a market like Las Vegas or Phoenix this kind of appreciation has occurred in less than two years and even in less than six months. Why would you want to tie yourself down to a higher interest fixed rate when you know that a refinance is very likely in the next few years simply to get rid of the PMI or second mortgage? If you put down less than 20% but you believe that the market will appreciate and get you your 20% equity in less than five years, then you should also strongly consider the ARM. Finally, it can be argued that a society of borrowers has been created, by interest only loans and ARMs, that will never "own" their homes. Most people used to buy houses under the premise that they would own their houses in 30 years. This was a goal and a dream. There is a new generation of homeowner that will find they live in a house for a period of time and are lucky to create any real equity outside of market appreciation. This may put them in a position where they they have to refinance their home into a new ARM every few years just to make sure they can continue to afford their payment. Right or wrong, it is the changing of the nature of the homebuyer and it is likely here to stay. The decision to go with an ARM vs. a Fixed is a very serious one. The wrong decision can be very costly. Make sure you consider all of the options before deciding.