With fixed mortgage rates still quite high compared to recent years, and ARMs finally providing a decent discount, you might be starting to look beyond the 30-year fixed.
The problem though is you’re probably still concerned that interest rates could skyrocket and that your ARM will adjust way higher in the future.
That’s always a concern with an adjustable-rate mortgage, which is why they’re discounted to begin with.
But one thing you can do to offset this risk and manage payments post-adjustment is to apply the monthly ARM savings during the fixed-rate period.
This way you’ll have a much smaller loan balance once the mortgage hits its first adjustment.
Use Your ARM Savings to Pay the Loan Down Faster While It’s Fixed
Let’s look at an example to illustrate what I mean using a $400,000 loan amount.
Imagine you can get a 30-year fixed today at 6.5% or a 7-year ARM for 5.375%.
That’d be $2,528.27 per month for the 30-year fixed versus $2,239.88 for the ARM.
That’s a difference of $288 per month. Over the course of the fixed-rate period (84 months), you’d save about $24,225. Not bad.
After 84 months, the loan balance would be $361,664.98 on the 30-year fixed and $354,410.53 on the 7-year ARM.
So on top of paying less each month, you’d also pay the ARM down faster because a bigger chunk of the payment would go toward principal due to the lower interest rate.
Those are the benefits of an adjustable-rate mortgage vs. fixed-rate mortgage, but there’s also the risk.
Namely that the interest rate can go up after the fixed-rate period ends. And potentially a lot!
Typically, adjustable-rate mortgage caps on a 7-year ARM allow the rate to increase as much as five percentage points at first adjustment.
That means a rate of 10.375% in the absolute worst-case scenario. That’s probably pretty unlikely, but it is the risk associated with an ARM.
Of course, in the meantime you might sell the property, or you might refinance the loan if rates happen to improve.
But if you are still holding the loan after seven years, you might face a higher fully-indexed rate (margin + mortgage index at month 85).
This could in fact be a decent rate if the mortgage index isn’t high at the time, but let’s pretend it is a little bit higher.
How to Get a Lower Monthly Mortgage Payment After the ARM Adjusts Higher
Say your fully-indexed rate is 7% at first adjustment. Using the balance of $354,410.53 and remaining loan term of 23 year, the monthly payment would be $2,586.91.
Not terrible. It’s about $60 more than the original 30-year fixed payment. And factor in seven years and it probably feels cheaper due to inflation.
But what you can do to bring this payment down even more, and offset some risk if the first adjustment is a lot worse, is to apply monthly savings to extra payments.
So during the first seven years, pay the extra $288 per month saved on the ARM.
At the beginning of year eight, when the loan first adjusts, the balance would be just over $325,000.
Now if we apply the fully-indexed rate of 7%, the payment is a lower $2,372.24. That’s about $150 less than the original 30-year fixed payment.
In addition, the lower loan balance might make it easier to refinance or sell due to the lower loan-to-value ratio (LTV).
So by paying extra using only the savings of the ARM, you build in some increased optionality to do other things if mortgage rates happen to be less favorable in the future.
Try out my early mortgage payoff calculator to determine possible savings of extra mortgage payments.
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