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.
Interest rates and mortgage rates have been coming down since the 1980s. Sure, there will be temporary bouts of elevated inflation for a year or two. But due to efficiency, technology, and a more intertwined world, interest rates will likely stay low for the rest of our lives. Paying a higher mortgage rate than you need is a suboptimal decision.
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 For An ARM
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 For ARMs
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 Will Lower Payments Once An ARM Resets
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. Fundrise focuses on single-family and multi-family properties in lower cost areas of the country.
Instead of taking a large concentrated bet in a single property, you can diversify across multiple properties with as little as a $10 investment each.
I’ve personally invested $810,000 in private real estate funds to earn more passive income and diversify into the heartland of America where valuations are cheaper.
2) Refinance Your Mortgage
Check the latest mortgage rates online for free. 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.
Jon Schwartz says
In other words, the curve is flat. And in some places, it’s inverted. This is good news if you’re on the receiving end of the equation, but not great as a fixed rate payer.
Trying to determine what the best approach is today…here are some details.
Looking for a home around $500k, and will have 200k available as a down payment. Want to focus on getting as low a monthly payment as possible, but also am wary of the 30 year mortgage given all of the above mentioned points.
However, whatever house we buy, we do expect to live in for at least 15-20 years, as we will have two young children.
Have a buffer of investments of about 475k, and have 75k earmarked for college.
Wife currently works, but wants to explore not working or potentially going part time for the next 3-6 years.
Live in Midwestern city, make an ok salary for here but certainly not anything impressive for most people on this site I’d imagine (about 80k).
The best 30 year rate I see today is about 4.3%, and the best 7 year ARM is about 4.15% from what I see.
Am I crazy, or did the spread between the 30 year and ARM rates just get much smaller, thus making the ARM mortgage options less attractive?
Financial Samurai says
You are not crazy. The spreads have narrowed as the Fed has been raising rates (shortest end). Therefore, we should be saving more aggressively in money market accounts and short-term treasuries (3-6 months). For example, CIT Bank is pay 2.45% for their money market account, which was unheard of just two years ago.
So yes, if you are a borrower, it’s making more sense to borrow over a longer duration of time. However, it’s still best to match fixed duration to the length of ownership or how quickly you plan to pay off the mortgage.
I’m seeing the ARM loans at 4.25% and above currently. As many of you have done, I did a refinance to an ARM at around 3.25% a couple years ago that will end in 5 years. I assume we are all in the same camp that rates will continue the down trend and just hold the ARM until the end.
The media portrays a scary picture of higher and higher interest rates…
You are very wise to keep a good chuck of cash handy for your Hawaii house ambitions. I can tell you from experience that having a larger down payment (or ability to pay cash with plans to refinance into a proper mortgage at a later date) is extremely important to your negotiating position. This is especially true if it’s a hot property with several people interested in it. Sellers usually go for the highest priced offer, but not always. Sometimes sellers will go with the buyer who looks like the best bet to be able to close on the house in the time specified, even if there are higher priced offers to consider.
On a related note, I’d definitely make friends with a few real estate agents in the market(s) where you’re looking in Hawaii. A good agent will be able to alert you to deals that aren’t on the public market (aka MLS) yet, which is a wonderful situation when it works out. I know some good agents in various places in Hawaii, so please hit me up if you need some suggestions!
I’m clearly not as educated as most folks commenting on this blog but have a pretty basic question on refinancing from a 30 yr to a 7/1 ARM.
I bought my home in Q1 2018 for $780,000 and owe $660,000 paying 4.75% (horrible time to buy but home of my dreams so don’t care). It was a new build so my property taxes went from $1200 to $6,800/yr, my bank increased my monthly payment by $1000/mo (delta from prior year plus reserves for next year)! I’m motivated to reduce my monthly fees now, long term game plan is to do what you’re doing, pay a substantial amount down on my principal before the 7 year lock is up. Goal is to start a family and stay in this house until they graduate high school. I have a long-time girlfriend/roommate that I plan on marrying and this is our home. I’ve always done 30 year fixed and your insights have helped me shift that paradigm.
Now my question: I can get a 3.375% Interest Rate, 4.47% APR 7/1 ARM through Ally Bank. I have read many definitions on APR but I still struggle to grasp the concept. The difference between the IR and the APR? How much do I have to pay attention to APR?
I have a 2.875% on a 30 year. Whether an ARM makes sense depends on the spread and your expectation of rates. I could have save a little bit on a 15 year or 10 year but locking in for 30 years was a no brainer.
In 2012-2014 it seems like a bad deal given rates have gone up and you got to itemize. In 2019 the equation is different if nothing else because of taxes.
I certainly would not make the statement that rates will remain low within our lifetimes.
Either way, most folks can’t dump $250K into an ARM to lessen the impact of a rate increase. I mean going ARM isn’t a bad strategy but has more downsides than upsides when the rate was so low to begin with. I only paid .375% more than you.
Spending more than you need is spending more than you need.
I have a 5/1 ARM at only 2.375%.
Most financially savvy people have the financial means to pay down debt.
Went from a 10/1 interest only in 2006 to afford a significant upgrade (and knowing income would improve)…to a 30 year fixed refinance in 2008…to a no cost 15 year fixed refi in 2011 @ 3.375%… to a no cost 10 year fixed refi in 2015 @ 2.75%. Now, seven years left at 2.75% fixed. I want to think I made the right call with the combo of fixed + reduction in years even though, in hindsight, that initial 10/1 interest only was probably not necessary.
Excellent. You are beating the system. Like it.
Sylvia | Keeping Up With the Changs says
My husband and I just bought a house in Hawaii. We were originally going for the 30-year conventional, but switched to an ARM after reading about them on your site.
We don’t plan to live here forever, but will be keeping it as a rental after we (hopefully) find our dream house. We got our foot into the dream neighborhood, but where I really want to be is basically across the street from where we currently live (are you familiar with Keolu Drive? I definitely have my eye on the Kaelepulu side of it).
Definitely bummed that we had to pay additional fees and mad that our realtor tried to tell us to stick to the 30-year mortgage (for his benefit), but glad to have come across your site and are saving at least $45,000 in the long run.
What areas are you looking in Hawaii?
Financial Samurai says
We’re looking at Waialae and Kahala area. We love the quiet beaches there, the club, and the proximity to Kaimuki.
I’m not aware of Keolu Drive. What neighborhood is that and how much does a 4/3 house on a 10,000 sqft lot cost there?
LJ Lyon says
Mr. Money Mustache got divorced and had to buy a house. I hope he read this post
Here is timeline of my loan on my primary home. I have refinanced twice to get better rate and currently paying 2.625 on 15 year fixed. There were no way anyone could have predicted how the rates will play up in next 6 months when I was financing it.
3.375 5/1 ARM July 2014 (Zero Closing Cost on principal 295K loan)
3.625 30 Year fixed refinanced in Jan 2015 18 MONTHS – 2015 (Zero Closing Cost on principal $290K)
2.625 15 year fixed refinanced in Aug 2016 ( $450 for appraisal and principal $250K)