Back when I was in the mortgage business—before the Financial Meltdown—I was always puzzled why people would take an adjustable-rate mortgage (ARM) when fixed rate mortgages were so low.
Is an adjustable rate mortgage a bad idea now?
With mortgage rates still very low, taking an adjustable rate mortgage makes even less sense.
Mortgage rates are near historic lows
According to Freddie Mac, mortgage rates bottomed out at 3.35 percent in November and December of 2012 (based on the 30-year fixed rate loan). They averaged 3.9 percent last month, which means that they’re barely 0.50 percent higher than the all-time low achieved five years ago.
Rates this low should cause you to lean toward the 30-year fixed rate. You’ll be locking in what are close to the lowest rates ever, for the next 30 years. And should rates drop substantially from where they are now, you can always do a refinance to take advantage of the better rate.
And if rates don’t drop—or if they increase—you’ll be fully protected by your fixed rate loan.
Adjustable rate mortgage “caps”—the devil’s in the details
Adjustable-rate mortgages typically have caps, which limit how high your rate can go. But caps are one of those seemingly minor mortgage details that, while explained at the closing table, tend to be forgotten once you’re in the house for a couple of years.
A common cap arrangement for an adjustable-rate mortgage might be something like “2/2/5”. That means that your mortgage adjustment cannot exceed two percentage points on the initial adjustment, two percentage points on any subsequent adjustment, or five percentage points over the life of the loan.
But while those caps exist to protect you from runaway mortgage rates, they can still do a lot of damage to both your house payment and your monthly budget.
For example, let’s say that you start out with a three percent initial rate on a 5/1 adjustable-rate mortgage, with a 2/2/5 cap structure. On a $200,000 loan, your initial monthly payment will be $843.
Your first interest rate adjustment
After the initial five-year term, your rate increases from three to five percent, limited of course by the two percent cap on the first loan adjustment.
Your monthly payment will then increase to $1,074. That will make it $231 higher than the payment was over the first five years. Are you getting uncomfortable yet?
Your second interest rate adjustment
At the end of year number six, you experience the second rate adjustment. The rate then goes from five to seven percent.
The monthly payment increases the $1,331. That’s an increase of $257 over the first rate adjustment payment, and a full $488 higher than the payment was when the loan began.
Your third interest rate adjustment
In year number seven, the rate goes up one more time. Since the initial rate cannot increase more than five percent over the life of the loan, your loan rate is now limited to eight percent.
That increases your monthly payment to $1,468, which is an increase of $625 over your initial monthly payment.
Despite the existence of the mortgage caps, the potential is real for your monthly payment to go well above the initial level. It’s even possible that the payment will get so high that you won’t be able to afford to pay it.
There’s something more as well
In the example above, we used an adjustable-rate mortgage with 2/2/5 caps. But it’s also possible to get one with caps of 5/2/5. In that arrangement, your interest rate could increase by a full five percentage points on the first adjustment.
That means that you can go from a three percent rate with an $843 a month payment, straight up to an eight percent rate with a monthly payment of $1,468 at the end of the first five years.
An adjustable rate mortgage transfers all the risk from the lender to you
The advantage of a 30-year fixed rate mortgage is that it is a virtually risk-free mortgage. Once you lock in your rate, there’s virtually no chance that the rate will go up over the entire term of the loan. And even though an adjustable rate mortgage may carry a lower initial rate, it’s almost certain that the rate will rise at some point in the future.
When you take an adjustable rate mortgage, you’re making several very optimistic assumptions:
- Rates will fall by the end of the initial rate term, enabling you to take advantage of even lower rates without even having to refinance (downward rate adjustments).
- Low mortgage rates will continue forever, so you can simply refinance at the end of the fixed rate term into either a lower fixed rate mortgage, or an even lower rate ARM.
- You plan to sell the home and move on within five years, so the rate situation doesn’t matter anyway.
If any of those scenarios does play out, the choice of an adjustable rate mortgage will have made perfect sense. But what if interest rates rise between now and the end of the initial fixed rate period?
All of those optimistic assumptions will disappear, and you’ll be faced with the darker side of the adjustable-rate mortgage arrangement. That’s how ARMs transfer all of the risk from the lender to you.
What if you don’t sell—or can’t refinance—in five years?
When borrowers take high risk loans, like adjustable-rate mortgages, they’re making positive assumptions about future events. But not every situation has a happy ending.
For example, let’s assume that you take a 5/1 adjustable-rate mortgage, under the assumption that your employer will be relocating you within five years. If the expected transfer doesn’t occur within five years, or doesn’t happen at all, you’ll be stuck with the darker outcomes that an ARM loan produces.
Here’s another scenario…You fully expect that you will be able to refinance into another mortgage that has either a similar or lower rate within five years. But lo and behold, mortgage rates jump to seven percent (or back up to their historic norm), and none of your refinance options are good.
But here’s the real nightmare scenario… You come to the end of the initial five-year fixed rate term, but you lost your job. The economy is in yet another recession (a typical cause of a job loss), and you can’t find another job that pays a comparable salary. But now, because you chose an adjustable-rate mortgage, your monthly house payment also increases.
What you save doesn’t justify the (much) higher risk of an ARM
Now that we’ve beaten the risk factors of adjustable-rate mortgages nearly to death, how much of a benefit you get for taking on all of that risk?
According to Bankrate.com, the average rate for a 30-year fixed rate mortgage this month is 4.11 percent. The average for a five-year adjustable rate mortgage is 3.52 percent.
That’s a difference in rate of just 0.59 percent per year. And that’s only good for five years.
In dollars and cents, that means a monthly payment on a $200,000 mortgage of $900 for a five-year adjustable rate mortgage at 3.52 percent, versus $968 for the fixed rate mortgage at 4.11 percent.
That’s saves you $68 per month, or $816 per year. Over the first five years, you will save $4,080. Of course, after the first five years, there’s no way to calculate if you’ll save any money at all, since you will then be dealing with the rate adjustments. Those rate adjustments may very well work against you.
Let’s also not forget that since mortgage interest is deductible for income tax purposes, that the $816 that you will be saving each year will actually be something less.
For example, if you’re in a combined federal/state marginal income tax rate of 30 percent, the $816 per year savings will be reduced by $245. That drops the net interest adjustment down to just $571 per year.
That’s when you have to ask yourself the question: does saving $571 per year justify the additional risks that come with an adjustable-rate mortgage?
For most people, I think the answer will be a resounding NO.
If you’re considering taking an adjustable-rate mortgage—under the assumption that you will save a bunch of money—carefully consider the risk you’re taking on for that savings. Those risks are very real.