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The truth about adjustable rate mortgages

Everybody does it. And often there’s no harm done. I’m talking about that social phenomenon known as the “herd instinct.” It happens when we allow our emotional mind to take precedence over our rational, thinking mind. It’s the kind of instinct that tells us to buy a “trendy” product even though the product may be significantly inferior, yet more expensive. In our defense, this behavior is simple survival instinct.

Choosing a mortgage isn’t life or death, so it makes sense to tune out the media hype and think. Adjustable rate mortgages have been unfairly lumped in with subprime/toxic mortgage products. The truth is that certain adjustable rate mortgages are the better choice for many homeowners.

The benefit of ARMs is lower payments and less interest expense. The risk is the possibility of a higher rate in the future. One of the first things that my clients say is “no adjustable or interest only” mortgage products, even before we discuss details of the many kinds of ARMs. Most people won’t use more than five years of their 30-year mortgage, so why pay for the extra years? Plus, with a little bit of forethought and planning, the risk of an ARM can be mitigated.

Homeowners in California and Nevada typically pay off their mortgage every five years. The reasons may include refinancing to a lower rate, moving to a larger/smaller home, monetary windfall (many Boomers are, or will be, beneficiaries of an inheritance), as well as marriage and divorce. Most young couples will purchase a “move up” home as their family grows, while military families and many upwardly mobile professionals relocate to further their careers, and mature couples scale down as their children grow. Homeowners may refinance to shorten or lengthen the term of their loan to manage their payments or to plan for retirement. So it’s no wonder that the typical mortgage pays off in about 60 months. So ask yourself if you really need a 30-year mortgage.

Assume you have a $250,000 mortgage. You can save a full percentage point by choosing a 7/1 ARM (fixed rate for the first seven years) compared to a 30-year fixed. At the end of the first 84 months, you would have saved over $17,100 in interest, plus you would have paid your principal balance down by an additional $4,774 compared to the 30 year fixed. That’s a $22,000 savings. That’s serious money. What’s the absolute, worst case scenario for our ARM? Imagine it’s the early 1980s (totally unlikely, considering how interconnected are the global economies and the immediate availability of information that drives Federal Reserve decision making) and rates have skyrocketed like a Saturn booster rocket. The 7 / 1 ARM has periodic interest rate caps in place that limit the annual and lifetime rate changes, such that at the end of 11 years when your adjustable rate mortgage has “maxed out” at 8.875 percent, your principal balance is within a hundred dollars of that stodgy 30-year fixed rate at the same point in time, but your cumulative interest savings is still $3,161 greater with the 7/1 ARM! So if you somehow happened to keep your mortgage for over twice the regional average time span and you elected to take no action in a time of rapidly rising rates until the year 2021 and if, against all imaginable odds, interest rates went through the roof – you’d still be better off with an adjustable rate mortgage.

But there’s yet another aspect that works in favor of adjustable rate mortgages. Interest rates historically travel in five to seven year cycles, meaning that there are typically about five to seven years between low points in interest rate cycles. If it turned out that you would be staying in your present home for more than six or seven years and you didn’t want to roll the dice with interest rates, you would have ample time to refinance into a new mortgage at an attractive rate.

Adjustable rate mortgages offer a compelling blend of benefits with the bottom line being more money in your pocket. So buck the trend, ignore the herd and think for yourself about your own situation and, as always, there is no substitute for working with a trustworthy, experienced mortgage professional. Not all mortgage lenders offer ARMs with the benefits discussed here. For many people in a broad variety of circumstances, the ARM benefits far outweigh the risks.

– Mark Treiber works with RPM Mortgage, located in Roundhill Center. Call 775-586-1130 for more details.


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