Adjustable Rate Mortgages Erroneously Dissed

Atrios, in a post titled “Has He Gone Insane?," states that he is a ”...little scared.  More than a little scared, actually.” What is he scared of?  Well, he’s scared because Alan Greenspan has recently stated that borrowers showed opt for adjustable rate mortgages (ARMs) rather than fixed rate mortgages (FRMs).  Atrios’ post points to a Bill Fleckenstein article at MSN Money titled “Don’t take mortgage advice from Alan Greenspan." Fleckenstein alludes that Greenspan’s advice to opt for an ARM is "reckless behavior."

Let’s consider this.  I, at one time, was part owner of a mortgage corporation and I have over 13 years of experience in this industry.  I have assisted over 2,000 individuals in financing their home, so I have a bit of expertise in this field.

A 30 year fixed rate mortgage interest rate today is running right about 5.25%.  If you mortgage $100,000.00, at this rate, your payment, principal and interest, would be $552.20 per month.  Not bad.  If you remained in the home for 5 years and then sold, you would have paid out $33,132.22 during that time.  Nice, safe mortgage.

A 1 year adjustable rate mortgage interest rate today is running right about 3.125%.  The 1 year ARM has what they call 2/6 caps.  This means the rate cannot increase more than 2% per year and no more than 6% over the life of the loan.  Thus the highest rate the 1 year ARM could increase to is 9.125%.  If you mortgage $100,000.00, at the rate of 3.125%, your payment, principal and interest, would be $428.38 per month.  Not bad.  In the first 12 months the total of those payments would be $5,140.51.  Let’s assume worst case scenario and the interest on this ARM goes up for months 13 - 24.  That means for the next 12 months the interest rate would be 5.125% and the payment would be $544.49 per month.  12 months of payments at that rate comes to $6,533.84.  Once again, let’s assume that the rate increase 2%, the max, for months 25 - 26.  That means the rate would go from 5.125% to 7.125%.  The payment also would increase to $673.72 per month.  12 months of payments at that rate comes to $8,084.62.  Once again let’s assume that the rate increases 2% for months 37 - 48.  That means the rate is now 9.125%.  The monthly payment also increrases to $813.63.  12 months of payments at this rate comes to $9,763.60.  Let’s assume that the rate does not change for months 49 - 60, that it remains at its maximum level for the fifth year, but remember, it could come down.  In the 5th year then, the payment would remain at the 4th year rate of 9.125% and the payment would also remain at 813.63 per month.  12 months of payments would then equal, once again, $9,763.60. 

Now let’s total that up.  Over 5 years, considering the worst case scenario for the ARM of 2% increases each year to the max of 9.125%, the total paid out would come to $39,286.17.  So the difference in out of pocket monies between a 5.25% 30 year fixed rate mortgage and a 3.125% initial interest rate 1 year ARM is $6,152.95 over a five year period.  But remember, just because an ARM rate can increase doesn’t mean it will increase.

So, there is a risk to taking a adjustable rate mortgage but it is nothing to be “scared” about and they are not “reckless behavior.” Just because an adjustable rate mortgage has the ability to increase, rate wise, does not mean it will.  Adjustable rate mortgages can also decrease.

Atrios and Fleckenstein should maybe do the math before running recklessly scared down the street hollering about the end of the world.

Posted by on 03/07 at 02:29 PM

  1. A brilliant analysis. And, as you know but others might not, there are hybrid fixed-adjustable products that give borrowers who understand that their needs will change in five to seven years (it’s three to five years in Arizona) the benefit of a substantially lower rate with no risk of ever facing an adjustment, either up or down. Plus which, a lower interest rate now qualifies the buyers either for more home or a lower payment with their current income, while any adjusted rate will be paid from a later, presumably higher income. Greenspan’s remarks on ARMs were dead on for most people under 50, and worth thinking about for at least half of those over 50.

    Greg Swann (Realtor)

    Posted by Greg Swann  on  03/07  at  08:21 PM

  2. Greg -

    Your point is correct.  There are 3/1 ARMs, 5/1 ARMs, 7/1 ARMs and 10/1 ARMS.  The first number in each ARM listed here meaning the loan is fixed for either 3, 5, 7, or 10 years and then adjusts on an annual basis.  Additionally, many of the ARM loans available can be converted to a fixed rate sometime during the period of the loan if the borrower so desires.

    Posted by  on  03/08  at  03:58 AM

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