Monday, September 26, 2011

Guest Post: In Defense of the Adjustable Rate Mortgage

Guest Post: Today I bring you a guest post, written by my husband as a birthday gift. He opted to give me the gift of time as I celebrated my birthday over the weekend. Instead of working on a post, I planted Spring bulbs. A truly lovely gift.

This is one of the best times to use a fixed-rate loan, but that doesn’t mean fixed-rate is the best choice for everyone.
In the wake of the collapse of the housing bubble, adjustable rate mortgages (ARMs) got a bad name. The Option ARM loan, which gave borrowers the option of paying more or less than the amount of interest accrued played a big role in the housing bubble. Each month the borrowers chose to pay less than the accrued interest, their balance would increase. When their balance hit some preset cap, they would be required to start paying at least the interest owed. In effect their minimum payment would jump. The fact that these loans had adjustable rates contributed to their volatility, but the primary problem was each month borrowers took the “option” of the minimum payment, they went deeper in to debt.

This is completely different from a standard ARM loan. The ARM amortizes (pays off) just like a fixed loan. An ARM’s rate is fixed during an initial fixed-rate period. After that it adjusts yearly based on some index rate. Usually there is a limit on how much the rate can change each year and on how I the rate can adjust.
Fixed rate loans have higher interest rates than ARMs. The longer the period of time the loan is fixed, the higher the rate. When you take out a fixed-rate loan, you’re are in effect paying insurance against rising rates. Each month you pay a little more. If in several year’s time rates go up significantly and you still have the loan, the insurance pays off. In any of the following scenarios, however, the fixed-rate loan does not pay off:
  • You pay off most of the loan during the initial fixed-rate period.
  • You sell the house during or shortly after the initial fixed-rate period.
  • Short-term interest rates are low after the initial fixed-rate period.
How to select the right type of ARM:
  • Select the fixed-rate period close to the amount of time before you plan to move or pay off all of the loan.
  • Find the highest payment possible in the worst-case scenario. The worst-case is that you make no extra payments to principal during the fixed-rate period and rates go up to the cap.
  • Pay a little extra on principal during the fixed-rate period. When the loan adjusts, they calculate the payment based on your balance at the time of adjustment and the new rate. A lower balance means a lower payment.
  • If you cannot easily afford the payment on a 30-year fixed loan, be very cautious about getting an ARM (or any type of loan). The ARM has lower payments, but it’s not a good way for someone who can barely afford a loan to save money.
Reasons not to Use an ARM
Interest rates are at historic lows. If rates rise significantly, it’s possible that people who take out a 4% 30-year fixed-rate loan today will be able to invest their money risk-free at 8% in the future. It is possible that inflation will rise above 4%, making the effective cost of a fixed-rate loan less than 0%. This situation last occurred the 70s when inflation and rates skyrocketed. The US Federal Reserve is currently taking steps to suppress long-term rates, reducing the cost of fixed-rate loans. Some critics fear this will lead to inflation similar to the conditions of the late 70s. This makes now one of the best times to use a fixed-rate mortgage if you plan to keep the loan for a long time.

If you chose to pay the higher rates associated with a fixed loan, make sure you are doing it for an intelligent reason not out of fear.

Charles J Gervasi is an electrical engineer who tries to be a frugal husband.

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