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No matter what today`s conventional 30-year mortgage rate is, how would you like one that is two points lower? You can probably get a loan that low with an adjustable rate mortgage (ARM), but you have to be willing to take some risks. It would also help to have a good idea of how long you plan to stay in your home. Like 30-year mortgages, ARMs are hitting record lows, explains Doug Perry, first vice president of the consumer markets division for Countrywide Home Loans in Los Angeles. A low-rate ARM is definitely the right loan for some people, he said, but not for all. To help you decide if you could benefit from this type of mortgage, let`s look at how an ARM operates.
If you get a conventional 30-year mortgage at 6.5 percent, for example, that is your rate for as long as you keep that mortgage. It doesn`t matter where interest rates go because your rate will stay at 6.5 percent. An ARM is also a 30-year loan, but the interest rate will change at least once, possibly twice, three times, or more. Let`s look at a one-year ARM as an example. You might be able to get a one-year ARM with a rate that is two-percent lower than you would get on a 30-year fixed. Of course, you might also have to pay a point -- one percent of the loan -- in order get that rate.
Perry notes that the shorter the term of the loan, the lower the rate. That`s because it`s easier to figure out where interest rates might be at the end of one year than it is after two years, or three, or 30 years. Even if the lender gets it wrong, there is not as much risk involved because the loan will either be paid off or a new interest rate will kick in at a predetermined time. The amount will be dictated by current rates, and by what sort of guarantees you have with your lender. We`ll look at those later.
If you know that you will be moving in a year or two, or even three, then it might make sense to go for an ARM and get the lowest possible rate for the time that you will be in the house. One thing to look at with ARMs is the cap -- the limit on how high the rate can climb and how long it will take to get there. Perry says that with Countrywide, as with most other lenders, there are both caps and loan limits. At Countrywide the loan rate will never go up more than two percent in one year, and it will never go more than six percent above the initial rate.
Let`s look at a "worst case scenario," Perry suggests. "Let`s say that the current rate for a 30-year fixed rate loan is 6.5 percent, and you get an ARM for an introductory rate of 4.625 percent. At the end of the first year your rate could go no higher than 6.625 percent, which is close to what you would have paid for the first year on a 30-year loan. The rate, however, could climb to 8.625 percent at the end of the second year. You can, however, refinance at any point -- although refinancing comes with its own set of expenses.
Now let`s look at what this means in terms of actual money when compared to a conventional, 30-year mortgage at 6. 5 percent on a $150,000 loan. Your monthly payments (principal and interest only) would be $948.10 per month, which would add up to $34,132 over the first three years of the loan. With the adjustable rate starting at 4.625 percent, your payments the first year would be $771.21 per month (principal and interest only), but your interest rate could reach 10.625 percent (assuming a 6 percent limit) at the end of three years. During the first three years of the loan, your principal and interest is close to what the 30-year fixed rate would cost, but then you would begin paying more.
The problem with the ARM begins when your adjustable mortgage rate is at 10.625 percent and the fixed rate remains at 6.5 percent. It is obvious that the major savings with an ARM come in the first couple of years when the introductory rate is low. Of course, there are other ARMs that could benefit you, depending on your circumstances. At present the three-, five- and seven-year ARMs offer introductory rates one to one-and-a-quarter points lower than the 30-year fixed.
Remember, too, that the above was a "worst case scenario." The interest rate on an ARM does not necessarily rise the maximum amount every year. The interest rate usually is based on the interest rate on the 1-year TCM (one-year Treasury bill). If the interest rate remains steady, the mortgage rate will remain steady. If the interest rate goes down, the mortgage rate will go down. For example, a homebuyer who got a one-year ARM loan two years ago has seen his/her rate go down twice since that time.
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