As you probably know, adjustable rate mortgages have lured aspiring homeowners with their attractively low interest rates. How low? Well, for the initial period of often five to seven years, they usually fall below the interest rate of a 30-year, fixed-rate mortgage. As a result, you would likely have a low monthly payment.
However, after that honeymoon period, ARMs adjust according to a predetermined index. In short, if interest rates go down, so does the rate on your ARM. But if they go up, your interest rate – and typically your monthly payment – rises, too, which is cause for concern.
Of course, ARMs do make sense for a lot of people. So read on for information that will help you decide whether to hold onto your ARM or look for new money-saving opportunities.
Interest Rates Will Likely Go Up
Since the interest rates on ARMs adjust after a set period of time, knowing where interest rates are headed would be helpful. But how can you tell where rates are going?
Well, in July 2014, the Federal Reserve confirmed that it would end what’s known as quantitative easing (QE4) in October. This decision will most likely increase interest rates. Here’s the simple version of why:
Beginning in January of 2013, in the QE4 program the Federal Reserve bought $85 billion worth of U.S. Treasury notes from U.S. banks every month, tapering off that amount beginning late last year. By buying these notes, QE4 increased the money that banks had to lend, increasing their competition for borrowers and therefore lowering interest rates.
Hence, when QE4 ends, rates will rise, says Jim Duffy, a senior loan officer with Primary Residential Mortgage, Inc.
“There’s absolutely no doubt that rates will rise once [the Fed] ends the stimulus. Rates only have one way to go when the Fed stops buying altogether, and that’s up,” Duffy says.
So how high will rates go? The Mortgage Bankers Association (MBA) projects rates reaching 5 percent for 30-year fixed rate mortgages by the second quarter of 2015. For comparison, as of September 11, 2014, the average interest rate for a 30-year, fixed-rate mortgage stood at 4.12 percent, according to Freddie Mac, one of the nation’s largest mortgage lenders.
But even a small jump in rates can have a huge affect on your ARM – and your wallet. Now, every situation is unique, but consider that a typical adjustment rate cap (the most your rate can adjust every adjusting period, usually each year) is 2 percent, according to HSH.com, the nation’s largest publisher of mortgage and consumer loan information.
We’ll assume that rates won’t rocket up by 2 percent a year and use half of a percent instead, along with a lifetime cap of 12 percent. This example shows how the monthly payment changes over the life of a $200,000 5/1 ARM that adjusts annually after year five, starting at a 3 percent interest rate.
Year Interest Rate Monthly Payment
1 – 5 3 percent $843
6 3.5 percent $890
10 6 percent $1,119
15 8.5 percent $1,327
20 11 percent $1,499
22 12 percent $1,553
Again, every situation is unique, so if you have an ARM, you should check the terms of your contract, but as you can see, things can get expensive fast.
Fixed Rates are Still Historically Low
The big attraction of ARMs, of course, is the very low initial interest rate. But that can blind many to the fact that even after the past year or so of rising rates, 30-year fixed-rate mortgage rates are still extremely low, historically speaking, says Ellen Davis, a senior mortgage banker for Corridor Mortgage Group in Columbia, Maryland.
She says that while every case is unique, this is a very good reason to lock in a rate for 30 years by refinancing an ARM. It provides peace of mind that if rates do go up higher and faster than expected, you’re still okay, Davis explains.
“Right now fixed rate loans are amazingly low, so refinancing might make [homeowners’] current payment a bit higher [than an ARM] but give them the security of knowing that the mortgage payment will not change,” she says.
And history does show that anything can happen. If you need proof, check out the average 30-year fixed-rate mortgage interest rate for July 1 of every decade from 1974 till now, according to the Federal Reserve’s historic data.:
July 1, 1974: 9.28 percent
July 1, 1984: 14.67 percent
July 1, 1994: 8.61 percent
July 1, 2004: 6.06 percent
July 1, 2014: 4.13 percent
How does that 30-year, fixed-rate mortgage look now? We thought so. And that’s without even showing you the 17.6 percent interest rate from 1982.
Fixed Rates Insulate You Against Inflation
A certain amount of inflation can be a good thing, which is why the Fed made one of its goals to stimulate it. For instance, slight inflation increases the value of things like your house. Of course, inflation also means the price of everything in your house, from the beer in the fridge to the couch you enjoy it on, also goes up.
But when you buy or refinance your home with a 30-year fixed-rate mortgage, you are essentially hedging against inflation, says Ian Aronovich, co-founder and CEO of GovernmentAuctions.org, a company that gives home buying and mortgage advice.
“As money loses it purchasing power, as has been the case for a while, it makes sense to take out a 30-year mortgage since you will be repaying it with dollars that are in all likelihood going to be worth less than they are when you bought the home,” he says.
Duffy says this helps offset other home and life expenses, too. If inflation does take hold, then as other things around the household eat up more and more income, it’s going to be very helpful to have a fixed rate and a fixed payment for housing, he says. As a result, people can control expenses, still put money away, and save for retirement.
“So you’re insulating your mortgage payment from inflation,” he says.
With an ARM, that insulation is not guaranteed, since your interest rate can rise along with everything else, notes Duffy.
ARMs Do Make Sense for Some
There’s a reason ARMs exist: They are a good product for some. In fact, our experts have identified three common situations in which an ARM might make a lot of sense.
The first is if you believe interest rates will go down in the future. Then, your rate will adjust down, not up. But we’ve already outlined why that’s unlikely.
The second situation when an ARM makes sense, says Davis, is if you plan to sell your home before the initial fixed-rate period of your ARM expires, or even soon after.
“Not all ARM holders should refinance. If their current ARM payment is low and they know that they will be moving within a certain period of time, that is a big part of the decision making,” she says.
The third scenario where an ARM may make sense is if you plan to refinance a home after you do some improvements, says mortgage broker Gloria Shulman, founder of Centek Capital in Beverly Hills. In that case, an ARM’s extremely low initial interest rate could save you a lot of cash, which you can use to fix up the home.
“For example, if you are buying a house you plan to renovate, it makes sense to apply for an ARM that can be refinanced when the house is worth exponentially more after you finish the work,” she says.