How can you save money with an ARM adjustable rate (variable rate) mortgage?

Most of the customers would agree that a fixed rate is better than a variable rate. I agree that this is true most of the time for most of the clients.

Nevertheless, I would like to explain the variable rate because it may make sense and save my clients some money sometimes.

The most common ARM is a hybrid ARM. It includes a fixed period and then it starts to vary. As an example, let’s analyze the 5/1 ARM with caps 2/2/5 and a 1 year LIBOR as the index.

The 5 in 5/1 is the period in that the rate is fixed (5 years), the 1 is how often it can change (once a year). The caps are there to prevent payment shock, and to prevent default if rates go up too fast and/or too much. The first 2 on the caps is how much the rate can go up on the first reset (when rates change and payments are recalculated), the second 2 is how much the rate can go up on subsequent resets and the last number 5 is how much the rate can change for the life of the loan.

Let’s see how the variable rate loan compares to a fixed loan. Let’s assume a $400,000 loan, 5/1 ARM 2/2/5 at 4.00% and a 30 years fixed at 4.25%. For the index, we use 1 year LIBOR and we are going to assume that it is growing more than the caps so we can see how it works. By the way, the rate is calculated by the base rate plus the index, subject to the caps.

 

ARM

Total

LIBOR (*)

 

Rate

Payment Balance

Payment

 

Year 0

 $400,000

Year 5

4.00%  $(1,893)  $361,371 ($113,592)

Year 6

6.00%  $(2,293)  $360,836 ($141,112)

Plus 3%

Year 7

8.00%  $(2,710)  $354,357 ($173,633)

Plus 3%

Year 8

9.00%  $(2,921)  $349,068 ($208,688)

Plus 2%

Year 30  $- ($979,894)
 

Fixed

Total Fixed Rate
  Rate Payment Balance Payment

Advantage

Year 0

 $400,000

Year 5

4.25%  $(1,949)  $362,771 ($116,936)

 $(4,743)

Year 6

4.25%  $(1,949)  $354,349 ($140,323)

 $7,277

Year 7

4.25%  $(1,949)  $345,570 ($163,710)

 $18,710

Year 8

4.25%  $(1,949)  $336,417 ($187,097)

 $34,241

Year 30  $- ($701,615)

 $278,279

The table above shows that if you plan to sell or refinance your house in the first 5 years it is better to go with an ARM product. The benefit is $4,743 and includes the sum of total mortgage payments and the mortgage balance at the end of 60 months.

There are other factors that affect the attractiveness of a fixed rate mortgage. Because a fixed rate mortgage implies less risk, it generally results on the lender willing to relax on DTI (debt to income ratio), and LTV (loan to value), which results in more buying power for the borrower. Therefore, a marginally smaller rate of the ARM product with lower initial payment, not necessarily will result in higher loan amount.

Many of my clients are very skeptical about the mortgage industry in general. They either have had a terrible experience themselves or know someone who had. I often spend a good amount of time explaining that we don’t do any of the loan products that caused so many problems in the past. The ARM products are a hard sell and there are no benefits for the lender either. In conclusion, despite the short-term benefit of an ARM product, I will offer the ARM products only when the client expresses the intent to sell or refinance the loan in less than 5 years or expressly ask for an ARM quote.

(*) The assumption used for the for the LIBOR is not an estimate. It is an extreme case so that we can show how the CAPS work. Please see below the 30 years history of the LIBOR.

Capture-LIBOR

 

 

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