You might be afraid of an adjustable rate mortgage increase once the introductory fixed rate period is over. However, there is always an adjustable rate mortgage increase cap that prevents the borrower from paying too much.
Let me explain how much an adjustable rate mortgage (ARM) can increase using my own 5/1 ARM example. In my strong opinion, taking out an ARM over a 30-year fixed rate mortgage is the best way to go to save money.
Adjustable Rate Mortgage Increase Cap
We bought a San Francisco single family fixer in 1H2014 for $1,250,000. We were tired of living in the north end of San Francisco for the past 9.5 years and wanted a change of scenery.
Originally, we had planned to relocate to Hawaii, but when we found our current house with ocean views, we though this would be a good compromise.
We put down 20% and took out a $992,000 5/1 ARM. Originally, I was going to put down 32%, because I had about $430,000 come due from a 4.1% 5-year CD. But with a mortgage rate of only 2.5%, I felt it was worth borrowing more and investing the difference.
The 2.5% 5/1 ARM was based on the one year LIBOR rate + a 2.25% margin – 0.25% discount for being an excellent customer. Back in 2014, the one year LIBOR rate was at only 0.5%, hence my 2.5% rate.
LIBOR As An Index
The London Interbank Offered Rate (LIBOR) is the average interest rate at which leading banks borrow funds from other banks in the London market.
LIBOR is the most widely used global “benchmark” or reference rate for short-term interest rates. Check out the historical one-year LIBOR chart below.
As you can tell from the one-year LIBOR chart, I bottom-ticked my mortgage rate in 2014. Some of you might be thinking that instead of getting a 5/1 ARM, I should have gotten a 30-year fixed rate instead.
But given my strong belief that we will be in a permanently low interest rate environment for the rest of our lives, I felt that paying 0.85% – 1.25% more for a 30-year fixed rate was a waste of money. So my actions followed my brain.
Besides, the average homeownership duration in America is only around eight years. At most, one may consider taking out a 10/1 ARM to match durations.
Matching ARM With Ownership Duration
As I planned to either sell my home within 10 years in order to buy a nicer home in Hawaii or pay off the mortgage during this time frame, to me, taking out a 5/1 ARM was worth the “risk.”
At one point during my 5-year introductory fixed rate term, LIBOR rose to about 3%. Based on a net 2% margin, this would mean my ARM could potentially reset to 5.25%.
If I end up paying 5% for the next five years, my average mortgage rate over a 10 year period would be 5% + 2.5% = 7.5% / 2 = 3.75%. 3.75% is pretty much in-line with the rate I would have gotten if I just locked in a 30-year fixed rate mortgage back in 2014.
However, with the money saved from not paying a 30-year fixed mortgage and the $100,000+ less in downpayment, I ended up investing the difference and earned a ~12% return on average from 2014 – 2022 because the stock market went up.
The percentage of loans that are adjustable loans is still under 5%. This is unfortunate because this means 95% of American mortgage borrowers are paying a higher interest rate than they should.
Terms Of My ARM Increase
But surprise! I didn’t end up paying an estimated 5% mortgage rate in 2019. Instead, based on my adjustable rate mortgage increase cap, I received a letter saying that I’ll be paying at most 4.5%. Have a look at the portion of the letter below.
The reason why my rate only goes up from 2.5% to 4.5% is that under the terms of my mortgage, my ARM can only reset by at most 2% after the initial 5-year fixed rate of 2.5% is up.
This maximum reset amount is pretty standard among ARM loans. But this reset amount is something you must have your bank point out in the document.
Maximum Mortgage Interest Rate
The other thing to note is that ARM loans generally have a maximum mortgage interest rate they can charge for the life of your loan. In my case, that maximum is 7.5%, but we’re never going to get there in my opinion.
Unfortunately, after one full year at 4.5%, my bank can raise my ARM by another 2%, bringing my mortgage rate up to 6.5% for year seven.
However, I doubt rates will keep on surging higher as the global economy slows. Instead, by the time my ARM reset occurs again in 7/1/2020, we might very well be in a recession with one year LIBOR rates moving back down.
What ended up happening was that before my five-year term ran out, I refinanced my 5/1 ARM into a 7/1 ARM at 2.625% with no fees in 2019. It was a difficult refinance, but one that I am so happy I did.
In 2020, I ended up buying a new primary residence and renting out my old house. Thankfully I refinanced my mortgage in 2019 because if I had waited until after I rented out my property, the mortgage rate would be at least 0.5% higher for rental properties. Always refinance before renting out your property to get the best rate.
Paying Down Principal
You can see from the letter that despite my mortgage rate increasing from 2.5% to 4.5%, an 80% increase, my monthly payment was only expected to increase from $3,919.60 to $4,079.33, a mere 4% rise.
The reason for the slight increase in monthly mortgage payment is because we’ve paid down 32% of our loan in 4.5 years ($992,000 down to $734,000).
Paying down over $250,000 in our mortgage was partly due to normal monthly principal payments coupled with random extra principal pay downs. Although the 2.5% interest rate is low, paying down mortgage debt has always been part of my long term investment strategy.
Following my FS-DAIR strategy, I would regularly try and use 25% of my free cash flow to pay down debt and use the other 75% to invest. Again, I’m just taking action based on my own advice.
I kept on paying down principal randomly until the 10-year yield breached 2.5% in December 2017. Once the 10-year yield was higher than 2.5%, I stopped because I was now getting an interest-free mortgage since I could simply invest the amount of my mortgage in a 10-year bond yield to cover all my payments.
If I had taken out a 30-year fixed mortgage for 3.625%, I wouldn’t have been able to experience interest-free living.
Your mileage will vary in terms of how much principal you actually paid down during the initial fixed rate period of your ARM. However, even if you didn’t pay down any extra principal during a five year period, you will have still paid down ~10% of your principal balance, depending on your interest rate.
Appreciation In Your Home’s Value
Even if you’ve got to pay a higher mortgage rate when your ARM resets, you may be pleased to discover that your home has appreciated in value during the fixed rate period. The higher interst rates go, it likely means there’s higher inflation due to higher demand.
In my example, the San Francisco median home price increased from $1,100,000 in 2014 to ~$1,650,000 in 2020, or a 50% increase.
A $550,000 median principal increase more than makes up for a measly $159.63 monthly increase in mortgage payment, roughly half of which is going to pay down principal anyway.
Again, your home’s appreciation amount will vary. Unless you timed your home purchase completely wrong, such as buying in 4Q2006 – 4Q2008, you’ll likely come out OK.
Even if you did purchase at the most recent peak, normal downturns usually last no more than 3-5 years with 10% – 20% corrections.
Make A Mortgage Pay Down Plan
When I got the letter stating my adjustable rate mortgage increase, I had a year before my mortgage rate was to increase from 2.5% to 4.5%. As a result, I came up with a mortgage pay down play during the remaining months. So should you once your adjustable rate mortgage is set to increase.
Bottom line, don’t be afraid of an adjustable rate mortgage increase. Rates likely won’t increase or increase by much. If mortgage rates do, you can always pay down principal or refinance to another reasonable rate.
Summary Of What Happens When An ARM Resets
1) Match the duration of your mortgage’s fixed duration with the estimated ownership duration or the length of time you estimate it will take to pay off the mortgage.
2) Paying for a 30-year fixed rate mortgage might provide you more peace of mind, but you’re likely overpaying for that peace of mind.
3) Read the terms of your ARM loan carefully and figure out what is the maximum interest rate increase during the first reset and what is the lifetime interest rate cap.
4) Try to make extra payments during your ARM’s fixed rate period to relieve potential interest rate pressure during the reset.
5) Don’t borrow more than you can comfortably afford = no greater than a 80% loan-to-value ratio with a 10% cash buffer after a 20% downpayment. Being overly leveraged is what consistently destroys people’s finances.
Real Estate Recommendations
1) Explore real estate crowdfunding
If you’re looking to buy property as an investment or reinvest your house sale proceeds, take a look at Fundrise, one of the largest real estate crowdfunding platforms today.
Fundrise allows you to invest in a diversified portfolio of mid-market commercial real estate deals across the country that were once only available to institutions or super high net worth individuals.
Instead of taking a large concentrated bet in a single property, you can diversify across multiple properties with as little as a $1,000 investment each.
2) Refinance Your Mortgage
Check out Credible, one of the largest mortgage lending marketplaces where lenders compete for your business. You’ll get real quotes from pre-vetted, qualified lenders in under three minutes. Credible is the easiest way to compare rates and lenders all in one place. Take advantage of lower rates by refinancing today.
In order to make more money, mortgage brokers and banks LOVE to scare the heck out of inexperienced homebuyers by saying their payments will surge higher once an ARM resets.
They don’t show them a 35-year historical chart of declining interest rates. By scaring their customers, they have a higher chance of locking them into 30-year fixed rate mortgages for fatter margins. Don’t be fooled. Mortgage rates have been trending down for decades.
What Happens When An Adjustable Rate Mortgage Resets And Increases is a FS original post.