Monday, February 19, 2007

Mortgage Lending - Fixed vs ARMs

Last week I wrote about various mortgage lending options, and why I think 9 out of 10 people should be using a standard, 30-year fixed rate mortgage. Today I'm going to make the case for ARMs - a few select people can take advantage of them, while the rest of us are getting fooled.

The basic premise behind an Adjustable Rate Mortgage is that the lender is going to give you an enticement on today's rate in exchange for you taking the risk on what interest rates are going to do in the future. The ARM will generally adjust once or twice per year, and the new interest rate will be based upon a set index (Prime rate, London Inter-Bank Offer Rate, etc.) plus a margin. On the good side, it will have a cap (maximum allowable interest rate change) for each adjustment and for the life of the loan.

The lenders are more than happy to let you assume the interest rate risk. And off the top of my head, if it makes the lenders happy, it probably isn't in your best interest. They know that today's rates are near historic lows, so there isn't much room for rates to go down in the future. If rates stay the same as they are today, you'll end up paying more than you would have in a fixed-rate mortgage due to the margin added to your index. And if rates increase, your rate will increase right along with them. By the time you realize you should refinance to a fixed-rate mortgage, rates will have already risen higher than what you could have had when you started.

So who can profit by using an Adjustable Rate Mortgage? People in specific situations, where they can benefit by purchasing their home today, and they have a rock-solid reason why their rising income will be able to offset their ARM payments rising, or their refinance at a higher rate. And by rock-solid, I'm talking about guaranteed, sure-fire reasons why the family's cash flow will be considerably better. Examples include:

  • Youngest child starts full-time school this fall, and the stay-at-home parent is going back to work 25 hours per week. Even if he/she earns $15 per hour, this increases the family's cash flow by $1,600 per month. They can buy the home of their dreams today, at today's prices, and know for sure they can cover the mortgage increases next year.

  • One of the borrowers is currently in school and will graduate within a year. His/her employer has a position waiting once the borrower has the necessary degree/certification, and the pay increase with the new position is substantial.

  • The borrower(s) have been paying $800 per month on student loans, which will be paid in full within a year. This will free up extra money for the mortgage. (and in this case, I highly recommend they refinance to a fixed rate mortgage once the loans are paid in full.)

Here are some of the other arguments I hear most often - and my responses to them!

  • "I'm only going to be in the home a short time." First of all, check your promissory note to see if there is a pre-payment penalty for early payoff. Many ARMs carry these. Next, if you're talking about being in the home for approximately one year, your buying & selling fees will be too expensive. If you're going to be there a few years, there is plenty of time for your rate to increase. And finally, what if your plans change and you end up staying there longer than you thought?

  • "I'm an investor and I want to maximize my cash flow." Firstly, any principle you pay shouldn't be part of the discussion; that's your money & you'll get it back when you sell the home. As for interest, what happens next year when your rates are higher? Why not lock in a fixed rate, so you know how much to budget and to forecast, while rates are near historic lows? Also, if you end up with great tenants and decide to keep the home for awhile, your mortgage balance will be reduced to zero over the course of 30 years.

  • "We'll figure it out later." Are you kidding me - that's the best plan of attack you can come up with? If the payment on a 30-year, fixed rate mortgage is too much for you, and you don't have a very specific plan for dealing with your ARM, this is too much house for you to afford. Period.

  • "I know for a fact interest rates are going to be lower next year." Oh, realllly?

By and large people have to look way too hard for reasons why an ARM would be a better loan for them. The upside to using an ARM is relatively small; the difference in payment on a $300,000 mortgage at 6.5% and 5.5% is about $190 per month. The downside, however, could be much worse.

In the end, I'll stand by my assertion that the 30-year, fixed-rate, fully amortized mortgage is the safest mortgage available, and is the right mortgage for 9 out of 10 homeowners.