Why Adjustable-Rate Mortgages Are Bad News Right Now

October 26, 2011 6 Comments »
Why Adjustable-Rate Mortgages Are Bad News Right Now

With mortgage rates as low as they are at the moment, you may be looking beyond fixed-rate options if you’re in the market to purchase a home or refinance your existing loan.

After all, while 30-year fixed mortgage rates are hovering around 4%, some 5/1 adjustable-rate mortgages are in the 2% range. This can certainly push your monthly mortgage payment lower.

And the interest rate on a 5/1 ARM is fixed for the first five years before becoming annually adjustable, so there’s relative safety there if you don’t plan on sticking around for long.

Let’s look at a quick example to illustrate:

30-year fixed @ 4%: $1432.25
5/1 ARM @ 2.75%: $1224.72

On a $300,000 loan amount, the difference in monthly mortgage payment is roughly $200 a month. Over five years, that’s $12,000.

Not an incidental amount by any stretch, but there has to be a catch, right?

(Advantages of adjustable-rate mortgages)

Well, we’re in a unique spot at the moment. Mortgage rates are pretty much in unprecedented territory.

They’re not rock-bottom, as they’ve risen in the past few weeks, but they’re still at lows not seen pretty much ever in our lifetimes.

Mortgage Rates Have Nowhere To Go But Up

Unfortunately, the general consensus is that mortgage rates have nowhere to go but up. That’s pretty much not debatable, but the big question is when?

They could rise quite quickly if the economy gets back on track, which is a must eventually, right?

So if you reside in a home that you plan on living in for the foreseeable future, gambling on an ARM right now may burn you in the future.

Sure, you may save money over the next 5+ years, but after that, you may find that mortgage rates have surged.

At that point, when your ARM is set for its first adjustment, it will adjust higher. And potentially a lot higher.

Don’t Choose an ARM If You Can’t Handle the Higher Payment

If you can’t handle that interest rate uncertainty, and don’t know if you’ll be selling before the adjustable period ends, an ARM isn’t a good choice right now.

Once interest rates rise, you’ll be stuck with a larger payment, or forced to refinance to stop the bleeding.

And even refinancing may be out of the question if you’ve got income restraints (debt-to-income ratio).

Think of it this way. At the moment, affordability is a lot higher because interest rates are really low and home prices have fallen from their highs.

In the future, assuming both home prices and interest rates rise, you may not qualify for a new mortgage. So you’ll be stuck with what you’ve got.

Would you rather be stuck in an ARM that’s constantly rising, or a fixed mortgage in the low 4% range?

Read more: 30-year fixed vs. ARM

(photo: Travis Hornung)

6 Comments

  1. Rick Sturgis March 17, 2013 at 11:29 am -

    In my case, I am looking to sell my home and buy a retirement home. I expect to sell my home and have approx $300k cash in hand. My thoughts are:
    1. Buy a retirement home for $280k with an ARM. I have an approved ARM at 1.85%. The ARM is based/arroved in conjunction with a $500k equity account with Merrill Lynch. The rate is based on the Libor.
    2. Invest the $300k in an equity based account investing in a broad and diverse set of stocks that pay 2-3% div….
    3. When the ARM rate exceeds the rate of reurn, cash in the stock and payy off the mortgage.

    Yes, a bit of risk that the equity capital investment stays constant to positve, but seems like a sound strategy. In order to maintain an investment posture that will allow me to continue taking advantage of current motgage and tax write-off?

    Your thoughts please?

  2. Colin Robertson March 18, 2013 at 9:23 am -

    Rick,

    It sounds like you’ve got the liquidity to pursue such as strategy, though it’s not without its risks. Most people don’t. So they won’t have that “Plan B” to just pay off the mortgage if investing doesn’t work out. However, stock prices may decline, especially seeing how expensive they are now. And if that forces you to pay off your mortgage to avoid a higher interest rate, you’ve effectively put all your eggs in one illiquid basket. Or at least $300k. So it reduces diversity in investment. And you miss out on a low, fixed rate for the life of your loan.

  3. Jeff June 28, 2013 at 12:11 pm -

    I’m currently in a 30 yr fixed at 5.99% and want to refinance ( a little late to the game). I’m only planning on staying in my current home for another 2-3 yrs. Would you advise a 5/1 ARM or 30 yr fixed?

  4. Colin Robertson June 28, 2013 at 12:31 pm -

    If you really only plan to stay for 2-3 years, the 5/1 ARM adjusting after five years won’t be an issue. But are you absolutely sure you’ll move before it begins adjusting? That’s the big question mark…or maybe it’s not if you’re certain you’ll be out. You also need to determine the savings (after refinance costs) if you’re only benefiting from the lower rate for 2-3 years.

  5. Angelo November 20, 2014 at 10:49 am -

    Would a 5 yr arm still work if I only have 75,000. 00 to put down on a 500,000.00 home? Total income is approximately 125,000. A year.

  6. Colin Robertson November 20, 2014 at 11:14 am -

    Angelo,

    You can shop around and see who offers a 5/1 ARM at 85% LTV. Or alternatively, you could look into an 80% first mortgage and a 5% piggyback second. But compare costs and rates to determine what’s best for you.

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