En español | Deciding on a home mortgage can be tricky business for older borrowers — especially if they're trying to choose between a conventional 30- or 15-year fixed-rate mortgage and an adjustable-rate loan (ARM).
ARMs offer the potential for big savings — a temptation to many homeowners in or near retirement and who want to lower household fixed costs. So should you take an ARM the next time you buy a home, downsize (or trade up) to a new place, or think about refinancing?
"With an ARM, you might free up many hundreds of dollars per month," says Keith Gumbinger, vice president at HSH.com, a mortgage information website. "That money could be put into your 401(k) or even stuffed back into your house, letting you lower your mortgage balance and build equity." (Disclosure: I've written freelance articles for HSH in the past.)
"But the problem with ARMs," says Gumbinger, a veteran mortgage pro with more than 30 years in the industry, "is that they're not without risk."
Guy Cecala, CEO of Inside Mortgage Finance, also acknowledges the risks inherent in ARMs. But he thinks they're currently a very good idea, given expectations for interest rates.
"Right now, nobody expects rates to decline," says Cecala. "We feel there's only one direction rates can go right now, and that's up. So if borrowers are looking for sub-4 percent rates, the new reality is that there are a lot of ARM products that look really attractive."
Here are four tips that can help you determine whether an ARM is right for you.
1. Know your alternatives
With most ARMs, the interest rate and monthly payment change at specific intervals: usually every month, quarter, year, three years or five years. The period between rate changes is called the adjustment period. So a loan with an adjustment period of one year is known as a one-year ARM, and its interest rate and payment can change once every year.
A loan with a three-year adjustment period is a three-year ARM. But there are also so-called hybrid ARMs such as 5/1 ARMs and 7/1 ARMs, which are increasingly popular. These loans are a hybrid between mortgages with a fixed-rate term and those with an adjustable-rate period. With a hybrid ARM, the interest rate is ﬁxed for the first few years, and after that, the loan adjusts annually until it's paid off.
A few lenders, such as Pentagon Federal Credit Union, offer 5/5 and 15/15 ARMs. With a 5/5 loan or a 15/15 loan, the ARM sets at an initial rate and then resets again and stays at that level for a fixed period. For example, a 5-5 ARM might have a 3.5 percent introductory rate for five years. When the loan resets five years later, it maintains the new, adjusted rate for another five years, repeating the cycle every five years.
"If rates are lower or about the same, great," Gumbinger says. "But if rates are much higher and your loan adjusted, now you're stuck with it for five more years. So it's a double-edged sword."
From his perspective, Cecala thinks PenFed's 5-5 ARM "could be the best of both worlds" for borrowers with a five- to 10-year horizon. That's because the loan starts out at an ultra-low 3 percent rate (as of late May) and has a 2 percent cap on the first adjustment. "That starting rate saves you a lot of money for the first five years," Cecala says. And with a maximum rate of 5 percent for the following five years, "that's nearly comparable to today's fixed-rate mortgages," he says.
2. Know your loan features
Before taking on any ARM, you need to know:
- What is the current rate, and what is the index? (The index is set by market forces, such as the London Interbank Offered Rate, or LIBOR.)
- What is the margin for this loan? (This is the lender profit added to the index.)
- How long does the initial rate last, and how often can the interest rate adjust?
- What are the periodic interest-rate caps, as well as the lifetime interest-rate cap? (This will tell you how high the rate could go.)
Many adjustable-rate loans are based on the 12-month LIBOR, which, as of late May, was 0.55 percent, according to HSH data. The typical margin on top of that is 2.25 percent. So it's not uncommon for today's ARMs to fall into the 2.75 percent to 3 percent range. This is why even though rates on traditional 30-year fixed rate loans in May 2014 were hovering in the 4.27 percent to 4.29 percent range, just above their lowest levels in a generation, many ARMs are more enticing because they offer even lower rates.
3. How long will you stay in the house?
Historically, the average U.S. homebuyer holds a mortgage for about six or seven years and then dumps that loan because they sell the house or refinance. More recently, though, buyers seem to be hanging on to their mortgages for longer periods.
A study by the website Credit Sesame found that the median number of years the typical American stays in a home has increased from six to nine years since the housing crisis. That's why, when it comes to ARMs, Gumbinger says getting these loans isn't simply a matter of "buyer beware," but more a case of "buyer know thyself," if you want to make the best mortgage decision.
Gumbinger says that if someone 50 or older has this typical scenario — say, five to seven years from now the kids will be out of college and the family won't need a big house in the suburbs — then a 5/1 ARM or 7/1 ARM could be worth considering. According to recent data from HSH.com, rates for 5/1 ARMs nationwide are right at 3 percent. Rates on 7/1 ARMs are slightly higher, at 3.4 percent.
"But the fact is, most people don't really know where they're going to be in five years or seven years," Gumbinger says.
Sometimes it boils down to this question: "How good are you with making plans for the future and then adhering to them?" Gumbinger asks. "And are you prepared if it doesn't work out for you? Because if your plans change, your mortgage must change as well."
4. Hedge your bet
Experts are almost unanimous in their thinking that — after so many years of very low interest rates — rates can only go one way in the near future: up. If you choose an ARM, run some "what if" projections.
"Calculate where you'll start with the loan, what's the worst-case scenario you might encounter, as well as a practical in-the-middle scenario," Gumbinger says.
After you crunch the numbers, decide if you'd be able to handle the loan at different levels. At the very least, you should be able to swing the midrange financial projection for your ARM. If not, rethink the loan.
Another tip: Build a cash cushion with your mortgage savings.
If refinancing into an ARM lowers your mortgage payment by, say, $400 or $500 a month, save those funds in a separate account that you don't touch. At least that way, you build a financial safety net to help offset and prepare for the time down the road if and when higher monthly payments occur. "Even if we get back to what are more normal rates — of around 7 percent to 8 percent — that would be very uncomfortable for some borrowers who've become accustomed to 3 percent or 4 percent rates," Gumbinger says. So the extra cash cushion you amass could offset some of that financial blow.
Both of these strategies allow you to hedge your bet a bit when using an ARM. But ultimately, if you take out an ARM, you have to resign yourself to the fact that there is some uncertainty about rates.
"Will you do better or worse in the future? It's a bit of a gamble," Gumbinger says. "You really don't know if it's going to work out or how it's going to work out."
That's why it's important to first shop around, educate yourself about loan products and know your time horizon, Cecala recommends. "Don't just think about what you can afford," but also "what loan will give you the most protection."
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