Interest Rates on the Rise.  How to Overcome Higher Rates with an Adjustable Rate Mortgage

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As mortgage rates rise, it might seem a bad idea to consider getting a five-year adjustable rate mortgage or ARM. Shouldn’t you get the lowest rate you can and lock it in for as long as possible? For some borrowers, getting an ARM in 2018 could be the best way to enjoy a shorter rate today. What happens in a few years could be less important for some homeowners.

People are looking more to ARMs in 2018 because rates are heading up. We have grown accustomed to great rates in the last four years. But the really low rate period largely ended after the November 2016 election. Freddie Mac reports that mortgage rates went up in the last nine weeks of 2016. That year ended with an average rate of 4.32% for a 30-year fixed loan. A five-year ARM at that time was only 3.30%.

Those rates were the highest in two years at the time, but they were much lower than the all-time highs in 1981 of 18.45%. They also were well below the average of 5.87% in 2005, at the height of the real estate boom.

Borrowers in 2018 should review their mortgage loan options to decide which will work best for their needs over the short and long term. When rates are low and going lower, people usually get a fixed rate loan. Many people in the last two years got a 15-year loan to take advantage of the extremely low rates. ARMS were only 7% of the total loan applications at the end of 2016. They are becoming more popular today. If you are considering one, it is helpful to learn more about them.

ARM History

Before the housing meltdown of 2008 and 2009, there were very creative ARMs available. You could get an ARM with a rate that changed each month. There were loans that allowed the balance to go up over time (negative amortization loans) and loans that determined your ability to repay with rates as low as 1%. Those days are over.

The ARMs of 2018 are much safer. These loans start as fixed rate loans for three, five, seven or 10 years, and then can adjust each year. The maximum increase of these loans is limited by caps.

For instance, the five-year ARM has a fixed, low rate for five years. Then, the rate will reset once per year for the last 25 years of the loan. The starting rate for this loan is about 1% below a fixed 30-year mortgage. The adjustment on the interest rate is based upon several thing:

  • Index, such as the Prime Rate or LIBOR Index
  • Margin, which is the amount that is added to cover lender costs and profit
  • Caps on the level the loan can go up to in one adjustment
  • Floor, which is how low it can go
  • Lifetime limit, which will keep the rate from going above a certain level

 

How ARM Will Adjust

A common 5/1 ARM is based upon the one-year LIBOR Index. As of early 2018, that index was at 1.70%. If you had a five-year ARM with a 2.75% margin (common), your new rate if it adjusted today would be 4.45%.

There is more to it. There are federal rules that limit how much the rate can adjust. Let’s say that you started at 2.25% and it was fixed for five years. Today your rate is going to adjust. If the terms are 2/2/5, this means the rate cannot go up more than two points in the first adjustment and no more than two percent for each future adjustment and can never be above 5% over the rate you started.

The starting rate was 2.25%. This means today it cannot be more than 4.25%, even if the index plus margin is 4.45%. Over the life of your loan, the rate will never be above 7.25%. Learn about the 7/1 ARM.

Is an ARM a Good Move?

It can be in the right conditions. A strength of the 5/1 ARM is you get a 1% or so lower rate in the first five years. This is an advantage if you intend to sell the home in four or five years. You will probably not have to worry about the ARM adjusting, or you may sell soon after it adjusts. In the five-year, low interest period, you could save the money you would have spent on the 30-year fixed mortgage.

Note that most people keep their homes an average of seven years. Younger buyers sell their homes faster, and older ones stay longer.

However, the major downside of the ARM is that rates can go up. It is possible that a 5/1 ARM with a 2.25% rate at the beginning could go up to 4.25% in year six, 6.25% in year seven, and up to 7.25% each year after that. This will not necessarily happen, but it can. Some estimates are the one-year LIBOR will hit 2.5% in 2020. If your ARM was adjusting in 2020, you could be paying 5.25%.

The bottom line is, an ARM can make sense if you are sure you will sell before the ARM resets. It also can make sense if you are confident you will be earning more money in five or seven years and can handle the higher payments. If you are heading towards retirement and plan to stay in the home, an ARM could be a risk.

But in a rising rate environment, taking an ARM can be a way to enjoy a low rate for three to 10 years. Just think carefully about how you will handle higher payments potentially after that.

 

 

References: What is Better a 5/1 ARM or a 15-Year?

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