An Adjustable Rate Mortgage (ARM) is simply a mortgage that offers a lower fixed rate for 1, 3, 5, 7, or 10 years, and then adjusts to a higher or flat rate after the initial fixed rate is over, depending on the bond market. I take out 5/1 ARMs because five years is the sweet spot for a low interest rate and duration security.
Fear of an excessive interest rate increase after the fixed rate period is over is the main reason why most homeowners take out a 30-year fixed mortgages. The other reason 30-year fixed mortgages are more popular is because banks have more wiggle room to earn a higher profit margin.
What’s important to realize is that there is a cap on how much the interest rate can increase during the initial adjustment period. There is also a lifetime cap on your mortgage interest rate if you decide to hold and not refinance. Finally, none of these caps may ever be realized if the 10-year Treasury bond yield or LIBOR doesn’t increase.
Despite the Fed continuously raising rates in 2019, I’m a believer that mortgage interest rates will stay low for a long time because US Treasury rates will stay low for a very long time. Therefore, taking out a 30-year fixed mortgage where you pay a 1% – 2% higher interest rate is suboptimal.
Notice how treasury rates have all been falling since the middle of 2018. We’re now back down to two-year lows, which means mortgage rates are back down to two-year lows as well. Paying for a premium for a 30-year fixed is a waste of money.
Remember, ARMs are different from negative amortization mortgages where the principal balance increases rather than decreases over time. Let me use my latest 5/1 ARM mortgage refinance to explain.
Example Of My ARM Refinance
What was refinanced: $981,000 mortgage at 2.625% with a monthly payment of $4,318. Principal portion of mortgage payment: $2,200. Interest portion: $2,218.
New mortgage: $850,000 at 2.375% with a monthly payment of $3,303.55. Principal portion of mortgage payment: $1,621.26. Interest portion: $1,682.29. I paid down a little over $130,000 in principal to qualify.
Study this chart below.
Notice the maximum my payment can go up is to $4,098 from $3,303.55 in the 6th year (1st year of adjustment). $4,098 is equivalent to a 2% interest rate hike to 4.375%. There’s another 2% maximum increase in the seventh year, whereby my monthly payment rises to $4,955 based on 6.375%. Finally, the maximum lifetime interest rate increase is 5% from my initial base level, or 7.375%.
This 2%/2%/5% lifetime interest rate increase is pretty standard for all ARM holders. In other words, there is no such thing as endless interest rate risk to ARM holders. Simply ask your bank what your interest rate caps are and your index, and margin e.g. LIBOR + 2.25%.
I don’t think we’ll ever get to 7.375% again in our lifetimes for a 5/1 ARM, but even if we do, paying $5,400 a month is not that big of a deal because my mortgage used to cost $6,800 a month 10 years ago when my principal balance was greater and when my initial interest rate was closer to 5.25%. Anybody who has owned a home for at least 10 years knows this.
The continued decline in rates for the past 35 years has been a boon for all homebuyers and homeowners. The market is softening now, but if you can find a good deal, can afford the payments, and know you plan to stay there for 10+ years, I’d rather get neutral inflation by buying than renting.
Here are five reasons why you shouldn’t worry about hitting your interest rate caps:
1) Depending on your interest rate, after five years you’ve paid down about 10% – 12% of your original principal balance. 10 – 12% less in principal means 10 – 12% less interest to pay. Consider this your interest rate buffer.
2) You can always “save the difference” in interest or cash flow savings with your 5/1 ARM payment versus if you took out a 30-year fixed. After 60 months of saving the difference, you’ll have a nice cash buffer in case you have to pay a higher interest rate. If I refinanced to a 30-year fixed at 3.625% instead of a 5/1 ARM at 2.375%, I’d be paying ~$82,000 more interest after five years. $82,000 equals 20 months of mortgage payments I’ve saved up. That’s an enormous leeway.
3) You can always pay down extra principal over the years. If you’re not satisfied with the automatic monthly mortgage pay down, you can always come up with a plan to pay down extra principal each month, quarter, or year during your fixed rate period. And if you’re really gung ho, you can just pay down the entire principal before the adjust period is over. I’ve always just lobbed an extra $1,000 – $5,000 after a particularly good month or a bonus. The extra payments add up nicely.
4) You will likely have a chance to refinance at some point before the fixed rate period is over like I just did after four years and two months with my previous 5/1 ARM. There will always be market volatility, especially in a five year window. When the stock market is crashing, the bond market is rising, and interest rates are falling. These are the best times to take advantage.
5) You already know the worst case scenario for your monthly payments. Once you know the worst case scenario, you will no longer be surprised if it happens. You’ll do things that will naturally protect you from downside risk. In fact, I might just start paying $5,400 a month (maximum payment at 7.375%) to get a feel of the worst case scenario now. At $5,400 a month, $3,718 of that goes to paying down principal. After five years, I will have automatically paid down $223,000 in principal, leaving me with only $627,000 to refinance. Even if I was so unlucky as to face a 7.375% rate, my new mortgage would still be a manageable $4,331 a month.
An ARM Is The Way To Go
It’s absolutely fine to refinance your 30-year fixed mortgage into a lower interest rate 30-year fixed mortgage. Taking advantage of this low interest rate environment is a wise move. But if you really want to save money, then I believe refinancing into a 5/1 ARM or purchasing a home with a 5/1 ARM is the way to go. Check online for the latest rates. I think you’ll be surprised how low rates are again.
After 13 years of being an ARM holder for various properties, I’ve saved around $500,000 in interest expenses so far. And each year that goes by I will probably save another $30,000 – 40,000 in interest expense by borrowing with an ARM than with a 30-year fixed mortgage. This is real money that can be used to live a more comfortable life or reinvest.
It’s absolutely shocking how much more interest rates have declined post Brexit. But with long bond yields at 0% or lower in many other countries, perhaps the US 10-year yield at ~1.35% still has a ways to decline. With interest rates so low, it’s difficult to see anything but a soft landing in the US housing market.
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Updated for 2020 and beyond.