Author Topic: Is an ARM a bad idea?  (Read 7221 times)

Dan T

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Is an ARM a bad idea?
« on: August 16, 2013, 10:22:22 AM »
I have a home that we purchased in 2009 for around $240k with 20% down, 30 fixed rate mortgage at 5%.  I went to my bank today for more info on refinancing, and their suggestion was a 5/1 ARM for 3% with no closing costs. 

My rough calculations are that this could save me close to $20k over the next 5 years, so it's very tempting.  However, I know that there are some negatives associated with the adjustable rate, and I'm wondering if these are just pitfalls for those who don't know what they are doing, or if I can really get screwed here.


katheh

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Re: Is an ARM a bad idea?
« Reply #1 on: August 16, 2013, 10:37:32 AM »
A 5/1 ARM is a mortgage that:

a) has a fixed rate for the first 5 years (in your case 3%) --but--

b) after 5 years it can adjust annually. The rate adjustment is based off the LIBOR, Treasuries, the WSJ rate, etc. The terms of the adjustment are negotiable and are written into your note (i.e. at the 6th year, it will adjust up or down by a maximum of 3%, just for example purposes).

Here is the problem.

a) There are 15-year fixed products on the market right now for not much more than 3% (3.5 seems about average).
b) With an ARM, in year 6, if interest rates are at 11% (right now for example the WSJ prime rate is 3.25%), then your rate will go up to 6%. In year 7, if the rates are still at 11%, your rate will go up to 9%, and so on, until they meet whatever index drives your rate.

Your rate could also go down (which is why these are seemingly attractive). ARMs were super popular from the mid-90s until 2004-ish because interest rates were really high. It wasn't uncommon for the fixed rate to be 7-8-9%, and that made a 6% ARM look really attractive. It was even more so when the prime rate dropped out, many ARM holders had their P&I go down during that time, but are just as exposed to it going up when interest rates eventually go up (which they eventually must).

For me, I would not get an ARM right now unless you plan to stay there 5 years or less. The lending rates are being artificially suppressed by the Fed and that situation is not going to go on forever. At some point interest rates must rise.

Dr. A

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Re: Is an ARM a bad idea?
« Reply #2 on: August 16, 2013, 11:39:03 AM »
For me, I would not get an ARM right now unless you plan to stay there 5 years or less.

This. Though, if you would be able to pay it off in 5 years that could work too.

I refinanced to a 10/1 ARM over the winter, and will save a bundle over that 10 years vs. a fixed rate. However, if rates merely return to their historical average, I'm going to give it back over the following 2 years. However, it is roughly 100% certain that I will not be living in my current apartment 10 years from now, so it was an easy decision.

My suggestion is to look at the rate adjustment terms, and see how long it takes to give back your savings if the worst-case adjustments happen at the end of 5 years. Then you can make an informed decision.

tomsang

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Re: Is an ARM a bad idea?
« Reply #3 on: August 16, 2013, 12:09:35 PM »
For me, I would not get an ARM right now unless you plan to stay there 5 years or less.

This. Though, if you would be able to pay it off in 5 years that could work too.

I refinanced to a 10/1 ARM over the winter, and will save a bundle over that 10 years vs. a fixed rate. However, if rates merely return to their historical average, I'm going to give it back over the following 2 years. However, it is roughly 100% certain that I will not be living in my current apartment 10 years from now, so it was an easy decision.

My suggestion is to look at the rate adjustment terms, and see how long it takes to give back your savings if the worst-case adjustments happen at the end of 5 years. Then you can make an informed decision.

Almost this, with the rate enviroment in the United States I would grab 30 year fixed rates left and right.  Even if you are planning on moving in 5 years, if this house would make a great rental you will be rewarded.  At some point, if rates go back close to their average/or median rates your loan will be worth quite a bit.

 

fiveoclockshadow

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Re: Is an ARM a bad idea?
« Reply #4 on: August 16, 2013, 04:35:13 PM »
It all comes down to how long you plan to have that mortgage.  Don't pay for interest rate protection beyond how long you will have the mortgage.

Your mortgage length is based either on:

1) How long you own the house
2) If you decide to pay off early

So if you know you will very likely move in five to ten years then a thirty year may be more expensive than a ARM.  If you are the type of person who doesn't like a mortgage and you plan to pay off quickly then a similar story.  Keep in mind though that if you can own the house for the full 30 years then that low rate might be a good thing to have.

Also look at alternatives like the PenFed 5/5 ARM. This adjusts only ever five years and can only bump 2% at a time.  So it is a decent product for a 10 year window.


Dan T

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Re: Is an ARM a bad idea?
« Reply #5 on: August 19, 2013, 09:25:54 AM »

Also look at alternatives like the PenFed 5/5 ARM. This adjusts only ever five years and can only bump 2% at a time.  So it is a decent product for a 10 year window.

This seems like a solid option.  Paying off within 10 years should be pretty feasible in the worst case.

mrHet

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Re: Is an ARM a bad idea?
« Reply #6 on: August 20, 2013, 04:32:11 PM »
Nobody mentioned that the 'no closing costs' really just tacks all of these costs on to the principal of the mortgage, stealing from the equity 'stash... 

I'd go for fixed so you don't have to roll more closing costs into a refinance when rates spike.

tooqk4u22

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Re: Is an ARM a bad idea?
« Reply #7 on: August 21, 2013, 03:46:49 PM »
Nobody mentioned that the 'no closing costs' really just tacks all of these costs on to the principal of the mortgage, stealing from the equity 'stash... 

I'd go for fixed so you don't have to roll more closing costs into a refinance when rates spike.

Not always true - sometimes it is, sometimes it is truly no cost, and sometimes it is blended into the interest rate (I have done this numerous times and benefitted me greatly as I refinanced as rates fell).

As for the questions, the previous responses are all good thoughts. With ARMs I focus more on risk first then on cost - so I would only consider an ARM if I can afford the potential for rising rates - i.e. if my mortgage is $100K then for the first 5 years it will be $421/month at the 3%.  At five years my loan balance would be $89,000 - lets say the rate goes to 7% my payment would go to $628/month based on remianing 25 years (+207/month) - if this is not big deal then it doesn't matter and it becomes more about capital allocation and maximizing returns/minimizing other debt costs. 

Also, if your mortgage is a low LTV then there is cushion there as well to refi/sell if needed.