Last October, I mentioned that I had finally hit a net worth of zero, celebrating the occasion of being officially worthless. At that point I mentioned that my next step was to buy a house. I can now say that I finally did get down and buy a house, closing on June 13th). I started looking in November just to see what was out there but didn’t seriously crack down and take it seriously until about April. I plan on writing a four-part series about my experience with the mortgage process and some of the hilarious and depressing encounters with the various people along the way.
Part 1: How I Learned to Stop Worrying and Love the ARM
Part 2: Realtors Bite
Part 3: The Long and Winding Road
Part 4: Thank You for Selling
As has been mentioned by my co-writer, mortgage rates have recently taken a little bump. With interest rates still historically low and a few of the Federal Reserve members starting to second-guess themselves, interest rates are still extremely low. I am personally a big fan of the adjustable-rate mortgage (ARM, in this case a 5/1 – meaning five years fixed rate followed by an adjustable rate adjusted every year). I enjoy the lower interest rate for the cash upfront. The reason I am writing this article is because everybody (and I mean everybody) who asked me throughout the process what loan I was getting, asked for clarification about how or why I would ever want an adjustable-rate mortgage.
My agent. The seller’s agent. My underwriter. My manager. Other co-workers. Other friends. The title company clerk. The WalMart cashier. OK, I made that last one up, but every single other one asked me why I was getting an adjustable rate mortgage with rates this low. Does this mean I think rates are going to go down? Or stay the same? Am I not worried about future payment increases? Didn’t I read that <insert magazine/60 minutes segment/MSNBC talking head here> claiming that ARMs are the cause of the recent recession as well as the impending apocalypse? Yes, I’ve seen them.
To be short, I work in financial services and have to deal with a lot of these questions everyday. ARMs did not cause the recession. They actually helped. Despite what some blowhard polemicists may claim. (editorial: how prescient of Paul!). Rates have never been lower and those who have stuck with their ARMs have been able to ride the interest rates lower, at a lower rate than 30 year fixed and without the need to pay a couple thousand closing costs in order to refinance!
I understand the appeal of the 30-year fixed rate and I think there is nothing wrong with it. It provides security in interest rate and payment over the entirety of a loan. The lender or investor takes on any interest-rate risk that will not expose the homeowner to too much volatility in mortgage payments. To me, the ARM vs. fixed boils down to one either/or. In my case, I saved about $175/month the first five years over the equivalent 30-year fixed rate I would have received. This equals a total of $10,500 over the first 5 years of my loan.
Is the security of the final 25 years of payment sufficient to pass up $10,500 in savings today?
That is the only question that needs to be answered. I believe that the answer could be yes or no depending on the individual’s risk profile and discount rate. For example, some mention that the average mortgage is only 7 years. This means that (I am going to be dangerous and assume the median is the same as the mean, and I understand that this is a faulty assumption) for half of homeowners, you are only securing 2 years outside of the adjustable-rate time period. Are you planning on renting the residence out? If so, rents are able to inflate and although they do not move lock-step with interest rates, it gives the homeowner flexibility to raise rent with the payments. The way I look at it, investors and companies set the spread between 30-year fixed and 5/1 ARM based off their risk profile and ability to withstand interest rate risk. Given I am much younger with a higher risk profile than most investors, then to me the security is not discounted enough meaning I should take the money up front.
In summary, I understand the risks in obtaining an ARM. I don’t think that it is simplified as security vs. risk. I think there are many factors at play and if you rephrased the question as a cost: Would you give up $10,500 to secure payment size? Either answer can be justified but that seems too expensive to me.
Stay tuned for the rest of this four-part series!