I heard the news about future interest rate hikes and thought it was about time for you to look into refinancing your mortgage if you have an Adjustable Rate Mortgage or ARM. If you do have an ARM, it may be time to consider contacting your mortgage company or perhaps a new lender altogether.
The Initial Conversation About an ARM
“I am interested in a fixed 30-year mortgage rate,” you said.
“May I ask why that is?” The broker asked politely.
“I don’t want to deal with the risk of rising interest rates. I cannot afford the risk,” you said.
“Looking at your last ten years of history, you have done pretty well with the adjustable rate. You had paid less in interest than most people with a fixed loan. May I suggest we look at some adjustable rates, which are even less than the rate you’re paying, and with caps, you don’t have to worry about the interest rate hikes? I think we can save you a few hundred dollars off your monthly payment.” The broker says.
At this point, the broker paused so that I could say, “No, thank you, and I am only interested in a fixed 30-year mortgage.” “I don’t understand. Are you not interested in saving money?” They asked before launching into a lecture with a mix of economy 101, budgeting 101, a dash of fortune-telling, and a healthy and unrealistic optimism of future trends in interest rates.
ARMs History
When done, I explained that I recalled reading about the 18%-19% interest on mortgage loans in the early 1980s that they were too young to know or remember. I pointed out that on a $100,000 loan, the 18% interest is $1,500 per month on the mortgage interest alone. If you have a $200,000 loan, the interest alone would be a back-breaking payment of $3,000 per month.
I knew they thought I was out of my mind thinking about an 18% mortgage interest rate in today’s environment. In the end, we ended the phone conversation without any resolution. The gap in understanding wasn’t about fixed-rate mortgages vs. ARM, and the gap was in age, experience, expectation, hopes, and fears, a gap too wide to bridge. If you do not remember these ultra-high rates, chances are your parents do. Ask them if nothing else.
To understand this gap, let’s look at ARMs. This type of mortgage loan is usually lower than the fixed-rate, and the lower rate means a lower payment, which means easier qualification.
When lenders consider your mortgage loan application, they look at what percentage of your income is available for repaying their loan. With an income of $5,000 per month, a $2,000 loan payment is 40% of your income, and a $1,000 payment is 20% of your income. The closer you get to $1,000 or 20% of your income, the easier it to qualify for the loan. This easier qualification appeals to younger people who are just starting and those with income limitations.
ARMs appeal to young people with an innate optimism, hopes of increased income, and the high possibility of moving to a different home in a short period. They need to look at what they can afford to pay and not worry too much about the distant future. Anything is better than renting, which is an absolute waste of money.
There are also those older individuals who have suffered from some setback in life and do not enjoy a high credit score or do not have a very high income. Since a poor credit score increases the interest rate a bank offers to potential borrowers, a fixed rate may be too high for these individuals to consider.
ARM Terms You Need to Know
Let’s look at some terms that help you understand ARMs better. For a more in-depth look at ARMs and some of the different types, visit ARM Information.
Margin – This is the lender’s markup and where they make their profits. The margin is added to the index rate to determine your total interest rate.
ARM Indexes – These are benchmarks lenders use to determine how much to adjust the mortgage. The more stable the index is, the more stable your adjustable loan remains. Consider both the index and the margin when you are shopping around.
Adjustment Period – Refers to the holding period in which your interest rate will not change. You will come across ARM figures like 5-1, which means your mortgage interest remains the same for five years, and then it will adjust every year after that. To see some 5-1 ARM rates visit Bankrate.
Interest Rate Caps – This is the maximum interest a lender can charge you.
Periodic caps – The lenders may limit how much they can increase your loan within an adjustment period. Not all ARMs have periodic rate caps, which is extremely important to know and understand.
Overall caps- Mortgage lenders may also limit how much the interest rate can increase over the life of the loan. Overall caps have been required by law since 1987.
Payment Caps – The maximum amount your monthly payment can increase at each adjustment.
Negative Amortization – In most cases, a portion of your payment goes toward paying down the principal and reducing your total debt. But when the payment is not enough to cover the interest due, the unpaid amount is added back to the loan, and your total mortgage loan obligation increases. In short, if this continues, you may owe more than you started with, as any excess interest not paid monthly is capitalized and becomes part of the new principal balance.
Negative amortization is the possible downside of the payment cap that keeps monthly payments from covering the interest cost each month.
Conclusion
As you compare lenders, loans and rates, remember Henry Moore, who said, “What’s important is finding out what works for you.”
With the Federal Reserve hinting at multiple interest rate hikes over the next year, it is time to consider getting out of an ARM and into a 30-year fixed-rate mortgage. Again, I do not recommend a 15-year mortgage. For more on my thoughts, visit Benefits of a 30-Year Mortgage.
If you are in or near the Nashville Metro area, feel free to contact me directly if you think of buying or refinancing a home. As a fee-only Registered Financial Consultant who is also a fiduciary, I can assist you with any financial matter you may have. If you are not in the middle Tennessee area, I can still help you or, if you prefer, seek out a qualified Registered Financial Consultant near you.
