An Adjustable Rate Mortgage…NOW?
Whether you’re looking for a mortgage or not, what the Fed is up to with interest rates is on everyone’s radar these days.
The upheaval caused by the pandemic set the economy on a new course that no one could have predicted in 2019. The economic stimulation that we enjoyed from years of low interest rates was, in 2020, set on a course towards inflation. The steps taken to stabilize the economy have created a financial shift for people tackling larger expenses such as buying a house.
Pre-Covid, over the course of four years from December 2015 through October 2019 the Fed raised interest rates in twelve increments from .25% to 1.75% – by today’s perspective a minor shift. On March 3rd of 2020, the rate was reduced to 1% and on March 16th, a further reduction to .25%. This remained unchanged until March of 2022 when the incremental increases began, rising from .25% up to 4.5% in one year alone, making this growth the fastest rate hike in history. To date, 2023 has seen an additional .5% increase.
What does this mean for a home buyer?
As a consumer, putting the brakes on inflation has helped us all with our day-to-day expenses. But as a home buyer, the extra percentage points have caused some reflection and readjustments to the best way to finance a house.
Five years ago, it was a no-brainer to lock into a rate and adjustable rate mortgages (ARMs) were less popular. In this high-rate environment, though, taking an ARM could be an easier path to acquiring property.
Why take a rate that might change?
The main reason would be that the rates, and therefore the payments, would be lower to start with. And remember that rates are cyclical, so in a few years you should be able to refinance.
Understanding ARMS
Adjustable rate mortgages come in 3, 5, 7, 10 and 15 year options. They are written like this: 5/1, 7/1, 10/1, 15/1. This means that the loan is set for the initial amount of years and then adjustable every year after that for the life of the loan.
Each ARM rate has annual caps, lifetime caps and a floor:
Annual Cap – This is how much the loan rate can move starting with the first adjustment period.
The 3/1 and 5/1 have annual caps of 2% – this means your rate cannot go up or down more that 2%.
The 7/1, 10/1, and 15/1 ARMS, however, often have a 5% jump for the first adjustment if index has greatly exceeded the starting rate. But any following rate increases can only go up a maximum of 2%.
Lifetime Cap – These are either 5% or 6% above the start rate.
Floor –The floor is the lowest your rate can go and is determined at closing. It can never be lower than margin.
Example – You have a 30-year loan at 5/1 with a start rate of 5.5%. In year 6, the most your rate can change in any given year is 2%, potentially making your rate 7.5%. However, it does not have to change the full 2% – this is based on where the Fed has rates at the time. And the lifetime cap for this scenario would be 11.5% if interest rates moved high enough to allow that.
Once they are allowed, changes of rate are based upon the combined rate of Index plus Margin.
- The 2 main indexes used are:
12 Month Treasury (aka 1 Year CMT)
Sofi Index
- The margin is usually 2.75%
If this amount is greater than your current rate, your interest will go up by the difference, not to exceed 2%.
The initial rate of a loan is usually not tied to anything. It’s a teaser rate that the bank chooses to give you. But that rate is yours for the time period you select and it can’t be changed during the initial commitment period.
ARM vs Fixed Rate Loan
Here’s an example of the initial difference between the two with a $500,000 loan.
5/1 at 5.5% – payment is $2,839
7/1 at 5.625% – payment is $2,878
10/1 at 5.75% – payment is $2,918
30 year fixed at 6.5% – payment is $3,160
Savings from having an ARM (for 5, 7 or 10 years) vs 30 Year Fixed
5/1 – savings in 5 years $19,260
7/1 – savings in 7 years $23,688
10/1 – savings in 10 years $29,040
Is an ARM for Me?
Generally, if you know you will be in your home for a short amount of time, ARMS really make sense. Or simply for a savings in what you need to pay out monthly.
But everyone’s situation is different and the best way to figure out if an ARM will work for you is to meet with a mortgage broker. Our extensive experience will allow us to point you in the right direction so you can find the best product for your particular needs.