Part 1 of Tales of a Mortgage: How I Learned to Stop Worrying and Love the ARM

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!

Cheers,

Cameron Daniels

Comments

  1. says

    At this point, it does make sense to look into that as an option with rising interest rates. Hopefully you can funnel the savings to cash and use that to pay things down further in the event the end of the ARM does not lead you to a favorable option.

  2. krantcents says

    An ARM is not a bad choice for your first home if you are only going to live there for five years. You may want to rent out your first home at some future date. If you decide to hold on to the property, you may want a fixed rate mortgage. There is more risk with an ARM, but it is minimal in the short run.

  3. says

    I’m looking forward to the rest of your series. I think the ARM isn’t a bad thing, but what was bad was people signing on for ARMs and not understanding (or not caring to understand?) what they were actually signing on to. And how many average people really keep up with the current LIBOR rates (or whatever your rate adjusts according to)?

  4. says

    NIce post, I think it is more risky to enter ARMs currently as the chances of rates rising in the next 5 years is quite high, but you can cover this by having an ARM with caps on what they can increase by. Definitely worth the 10K for me!

  5. Jacob @ iHeartBudgets says

    What’s your cap? If you’re capped at like 6%, then you’re good to go. And yes, cash now has more power than possible future cash, but I am not opposed to ARM’s like I used to be in my Dave Ramsey days. I got a fixed, and ReFi’d at 3.25%, so I’m happy, and my risk tolerance is VERY LOW because of one-income household, baby at home and another on the way.

    Congrats on the home, you’ll LOVE being a homeowner :)

  6. says

    Congrats
    on closing on your house, I think I would have gone for ARM as well. I have a
    flexible mortgage that goes up and down following base rate and so far, base
    rate hasn’t moved in over 4 years. If payments increase for you in 5 years, so
    will have your salary hopefully, and the % of income going to your mortgage will
    be the same or maybe less than today, it is worth a shot.

  7. says

    Congrats again, I know I’ve told you a few times. I’ll get down there eventually and teach you all the dirty tiling tricks I know (ha).

  8. AvgJoeMoney says

    Agreed, Cameron. The difference between an ARM and fixed rate mortgage? You have to stay on top of it. When people tell me that they don’t trust themselves to stay on top of their financial picture I often wonder if they know what they’re really saying….

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