The popular 30-year fixed, which was priced as low as 2.65% in early 2021, is now closer to 6%!
At the same time, alternative loan products like the 5/1 ARM are now pricing at a sizable discount.
For example, the 30-year fixed averaged 5.81% during the past week, per Freddie Mac, while the 5/1 ARM came in at a much lower 4.41%.
That discount can save you a lot of money on your home loan for the first five years. Here’s how to make that discount even more powerful.
ARMs Are Back Because They’re Finally Cheap Again
As noted, adjustable-rate mortgages are staging a bit of a comeback. They held a nominal share of the overall mortgage market for years.
Simply put, they priced the same or very similar to fixed-rate mortgages, so there was virtually no reason to get one.
But in the latest week, they accounted for 10.6% of total home loan applications, per the most recent report from the Mortgage Bankers Association (MBA).
While this is still a small share overall, it’s much higher than the paltry 2-3% share ARMs held for many years when fixed-rate mortgages were silly cheap.
Of course, times have changed, and fixed-rate mortgages are no longer anywhere close to their record lows.
The 30-year fixed is pricing around 6% and could be headed even higher in coming months.
This has caused prospective home buyers, and those looking to refinance, to consider other options.
One of the most popular adjustable-rate mortgages is the 5/1 ARM, which is fixed for 60 months before becoming adjustable for the remaining 25 years of the 30-year loan term.
It’s a hybrid ARM in that it provides a fixed-rate period and an adjustable period.
At the moment, the spread between these two products is about 1.5%. That’s a pretty wide margin.
You Can Save a Lot with an Adjustable-Rate Mortgage Today
If we consider a $500,000 loan amount, the monthly payment would be $2,533.43 on a 5/1 ARM set at 4.5%. And $2,997.75 for a 30-year fixed set at 6%.
That’s a difference of $464.32 per month. Clearly that’s a nice little money-saver you can enjoy for a full 60 months.
After those 60 months are up, the 5/1 ARM may adjust higher, which is why you get the discount.
Conversely, the 30-year fixed features an interest rate that never changes during the 30-year loan term. That’s why you pay more.
On top of the monthly savings, the 5/1 ARM would pay down the principal balance faster due to the lower interest rate.
The outstanding loan balance would be $455,789.35 after 60 months if you opted for the 5/1 ARM set at 4.5%.
Those who went with the 30-year fixed would have a remaining balance of $465,271.97 after 60 months.
So the borrower with the ARM saves about $460 per month AND has a lower loan balance five years later.
That’s pretty sweet, but here’s how it can be even sweeter.
If You Can, Make the Comparable 30-Year Fixed Payment on the ARM Each Month
|Loan amount $500,000||30-year fixed||5/1 ARM||5/1 ARM paying extra|
|Balance after 60 months||$465,271.97||$455,789.35||$424,612.37|
Instead of paying the lower monthly payment required on the ARM, pay the comparative 30-year fixed payment.
So if you were quoted a rate of 6% for a 30-year fixed and the monthly payment would have been $2,997.75, pay that for the first five years.
Or for however long you keep the mortgage before selling the home or refinancing the mortgage.
You should be able to afford the fixed-rate option even if you opt for the ARM, so it should be a payment you can make.
If you can only qualify for a mortgage using an ARM, you may want to rethink the decision.
Anyway, let’s imagine you made the 30-year fixed payment of $2,997.75 for 60 months on your ARM.
This would entail paying $464.32 extra per month. When making your monthly payment, your loan servicer should provide the option to pay an additional amount toward principal.
The extra $464.32 would go straight to the outstanding loan balance and reduce your interest expense each month.
In short, a smaller loan balance means less interest accrues.
This means more of each dollar goes toward paying down your mortgage, instead of winding up in the banker’s pocket.
If you did this for the full 60 months, your loan balance would be $424,612.37 at the time of first adjustment.
A Safer Adjustable-Rate Mortgage?
People are down on ARMs because they can adjust higher. Rightfully so.
For some folks, they might not be able to afford the higher monthly payment once it adjusts.
This could mean losing their homes. Obviously that’s bad. But if you’re financially able, an ARM can provide substantial savings, as evidenced above.
And if you pay extra each month (because you’re saving hundreds monthly vs. a fixed-rate loan), you can save even more.
On top of the savings, you’d have a much lower outstanding balance after the fixed period came to an end.
This could provide a safety buffer if your interest rate adjusted significantly higher at that time.
The loan balance would be more than $31,000 lower than the ARM borrower who paid the regular amount monthly.
And it would be over $40,000 lower than the borrower who opted for the 30-year fixed set at 6%.
So even though you’d be subject to an interest rate adjustment, you’d have a $40,000 head start over the fixed-rate mortgage homeowner.
This would make your new monthly payment lower than what it would be if you made the minimum required payment each month.
And it could make it easier to refinance into a new mortgage thanks to a lower loan-to-value ratio (LTV).
It would basically save you even more money, and make any interest rate adjustment less painful.
Your effective mortgage rate would also be lower since you’d pay even less interest than the ARM borrower making the minimum payment, and much less than the fixed-rate borrower.
Just something to think about if you choose an ARM and have the means to pay more toward the mortgage each month.