Guest Post Courtesy of:
Mark Anderson NMLS # 374393
Vice President Direct Lending Division
Cornerstone Mortgage, Inc. NMLS 223109
Phone/Text # 314-599-0511
How long do you plan to own your new home? This is one of the first questions I ask clients to help determine their mortgage needs. Most folks throw out a vague number of years, not really knowing for sure. Others are adamant they will be in the home forever. However, some people have a very definitive answer and can tell me right off the bat. For example, I have found in particular that medical students, fellows, residents, etc. often know exactly how long they want to stay. For these buyers, adjustable-rate mortgages (ARMs for short) are a great option, allowing them to save thousands of dollars effortlessly.
Turning Jargon into English: The first thing to understand about ARMs is that most of them are not true adjustable-rate mortgages at all! In fact, in my 10 years as a mortgage banker, I have never closed a true ARM. The kind of ARMs I am going to discuss here are technically referred to as “Fixed-Adjustable Hybrid Mortgages” (I guess we could call them FAHM’s, but that doesn’t have a very nice ring to it.) The word ‘fixed’ is the aspect we’re interested in here. In a true ARM your interest rate would adjust on a monthly or yearly basis, subjecting you to a high degree of risk. In the fixed-adjustable hybrid version, your rate starts out FIXED for a predetermined amount of time.
When looking at these types of ARMs you will see two numbers and a slash – for example, 5/1 or 7/1. The number before the slash refers to the number of years the rate will be fixed. The number after the slash refers to how often that rate will adjust once the fixed period is over. So, in the case of a 10/1 ARM, the initial loan rate will stay fixed for 10 years. After 10 years, it will adjust once per year. I could go on to explain how the adjustments work, but for the purposes of this conversation we are assuming the loan never goes into adjustment because you would sell the property before the adjustable period is over.
Reasons to consider an ARM: Assuming you know how long you are going to own the property and that you choose a fixed period that matches up properly, you should seriously consider an ARM because it will save you tons of money versus a traditional 30-Year Fixed mortgage – it is that simple.
Example: To help demonstrate these numbers, I wanted to use a real, live example of a property that is for sale right now! Dawn Griffin has currently listed 5351 Pershing Ave. St. Louis, MO 63112 at $299,000. We chose this property for this example as it is in an area near Washington University Medical School, which means there are many prospective buyers that could benefit from an ARM versus a fixed rate loan.
Assumptions: I am going to assume a 20% down payment, though technically you could put much less down. In addition, I am going to assume a 740 or higher credit score. Finally, as a legal caveat, I have to explain that the rates mentioned below are subject to change without notice but that they are valid rates for the day I am writing this (3/3/2015).
30 Year Conventional Fixed Rate: Current rate would be 3.75% (3.799% APR). If you stayed for in the home for 5 years you would spend $42,731 in interest. Over 7 years, you would pay $58,507. And if you lived there 10 years, you would make $80,576 in interest.
10/1 ARM, current rate would be 3.5% (3.277% APR). Over 10 years you would spend $74,899 in interest – a savings of $5,677 versus the fixed rate program. Over 7 years, you would spend $54,452 in interest – a savings of $4,055. Over 5 years, you would spend $39,802 in interest – a $2,929 savings.
7/1 ARM current rate would be 3.125%. Over 7 years, you would pay $48,403 in interest – a $10,104 savings versus the 30-year fixed loan. Over 5 years, your total interest spent would be $35,426 – a $5,672 savings.
5/1 ARM current rate would drop to the quite enviable 2.875% interest rate (2.956% APR). Your total interest payment over 5 years would be $32,521 which is a savings of $10,210 compared to the 30-year fixed.
Make no mistake, while these savings are fantastic, they have the potential to evaporate quickly if rates shoot up after the fixed period is over*. One option to consider is to give yourself a buffer. If you only plan to be in the home for 5 years, you might consider taking the 7/1 ARM or even the 10/1 ARM. The savings are still significant and you will have some additional peace of mind.
In closing, let me share a quick observation. I took a look at my purchase clients that closed in 2008. By my records and best efforts to interpret them accurately, a full 50% of the clients that took 30-year fixed rate loans have already sold the property or refinanced. That means that every single one of these clients could have saved significant money by using a 10/1 ARM. Is the product right for everyone? Absolutely not, but they can be a great way to save money when used in the right circumstances.