When to opt for an adjustable home loan

Part 2: Choosing a mortgage

By Inman News Feed
Add Comment Add Comment | Comments: 1 | Posted Jun. 27, 2011

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Part 2: Choosing a mortgage

Jack Guttentag
Inman News™

Editor's note: This is the second of a three-part series.

Adjustable-rate mortgages (ARMs) are only about 10 percent of the market today, yet I would guess that perhaps half of all new borrowers would select an ARM if they understood them. Fear of the unknown and the risks associated with the unknown generate a safety-first knee-jerk, which is to retreat to the fixed-rate mortgage (FRM) that has no interest-rate risk.

On May 27, the zero-fee rate on a 7/1 ARM was 3.375 percent, or 1 percent lower than the rate on a zero-fee 30-year FRM. This translates into a monthly payment difference of $57 per $100,000 of loan amount. Over the seven years for which the initial ARM rate holds, the cost to the ARM borrower relative to the FRM borrower would be more than $7,000 less per $100,000 of loan amount. That is a significant benefit.

The risk to ARM borrowers is that they will still be in their house after seven years, and that the rate and payment will increase. But the risk on an ARM can be measured and understood. Borrowers who take the trouble to do that may decide that the risk is too large to justify the benefit. Or they may decide that the risk is worth taking.

The borrower taking an ARM can reduce the risk by making the larger FRM payment. The larger payment results in a larger balance reduction, which reduces the payment increase following a rate increase.

Step 1 is to quantify the risk of taking the ARM. I do this by first defining alternative scenarios for future interest rates. Then, for each rate scenario, I calculate both the highest future payment and the total cost relative to that of the comparable FRM. Cost is calculated in the two cases where the ARM borrower makes the ARM payment or makes the FRM payment. The table shows results for the 7/1 ARM and FRM described above. Positive numbers in the table indicate that the borrower would benefit from a cost standpoint taking the ARM rather than the FRM.

Monthly Payment and Total Cost of 7/1 ARM and 30-Year FRM Under Different Interest Rate Scenarios, Priced on May 26, 2011

 

Assumption About Future Interest Rates

No-Change

Small Increase

Moderate Increase

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1. Jeremy Gilbert said... on Jul 20, 2011 at 11:32PM

“Adjustable home loans provided people with all credit grades the ability to buy homes or refinance their mortgages just a few short years ago. Adjustable home loans offered lower rates then a fixed rate loan and this helped people buy a little more house then they could afford with a fixed rate loan

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