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Adjustable-Rate Mortgages (ARMS)

Lately It’s been tougher out there for homebuyers. The median U.S. home price has rise quite dramatically in the last couple of years and on top of that, the cost of a 30-year fixed rate mortgage has gotten much pricier too, with (Today’s rates are 6.764% on a 30 year fixed up from 2.88% a year ago.)

The real estate market has definitely been cooling, in competitive housing markets all-cash offers and bidding wars were common until recently and Buyers were under pressure and they were making all kinds of concessions to get into houses, including skipping home inspections and waiving other contingencies. But now inventory is up, interest rates are up and there is more time to make a good decision on purchasing a home

Making the correction decision on the type of Loan that will work best for you is one of the biggest decisions you will make when purchasing a home.

Right now taking out an adjustable-rate mortgage is now one strategy buyers have been turning to in an attempt to lower their monthly housing payment. It’s becoming more common especially in expensive housing markets

Adjustable-rate mortgages typically start out with a lower-than-average interest rate, and then “adjust” to a higher or lower rate (depending on where fluctuating, market-determined interest rates stand when the adjustment happens, and other factors) after a set period of time. A 5/1 adjustable-rate mortgage (ARM), for example, changes its interest rate once a year after five years. Borrowers sometimes take out an adjustable-rate mortgage if they think they’ll be selling the house before the rate adjusts.

ARMs or Adjustable rate Mortgages can be attractive because borrowers will initially have a lower monthly mortgage payment than they would with a traditional 30-year fixed-rate mortgage. Right now the introductory rate on a 5/1 ARM is 5.706%

vs. 6.764% for the 30-year fixed.

You may remember adjustable-rate mortgages that preceded the 2008 housing crash and Great Recession. ARMs were popular with buyers looking to get a piece of the housing boom. Lending standards were looser then, leading to situations where lenders approved mortgages for borrowers even if they couldn’t actually afford to pay it off.

ARMs today are less risky, thanks in part to borrower protections established by the Dodd-Frank Act. Dodd-Frank require lenders to fully document a borrower’s income and assets and their ability to repay an ARM before the loan is made, and borrowers must qualify for the loan based on the fully-indexed rate, not the introductory or “teaser” interest rate.

1. Adjustable-rate mortgage – Best for borrowers who aren’t planning to stay in the home for an extended period, would prefer lower payments in the short-term and are comfortable with possibly having to pay more in the future.

· Unlike the stability of fixed-rate loans, adjustable-rate mortgages (ARMs) have interest rates that fluctuate with market conditions. Many ARM products have a fixed interest rate for a few years before the loan changes to a variable interest rate for the remainder of the term. For example, you might see a 7-year/6-month ARM, which means that your rate will remain the same for the first seven years and will adjust every six months after that initial period. If you consider an ARM, it’s essential to read the fine print to know how much your rate can increase and how much you could wind up paying after the introductory period expires. And if there are any penalties for refinancing early.

The Pros of ARMs

  • Lower fixed rate in the first few years of homeownership (although this isn’t a guarantee; lately 30-year fixed rates have actually been keeping pace with 5/1 ARMs)

  • ARMs Can save a substantial amount of money on interest payments

The Cons of ARMs

  • Monthly mortgage payments could become unaffordable, resulting in a loan default

  • Home values may fall in a few years, making it harder to refinance or sell before the loan resets

Who should get an ARM?

· If you don’t plan to stay in your home beyond a few years, an ARM could help you save on interest payments. However, it’s important to be comfortable with a certain level of risk that your payments might increase if you’re still in the home.

· The typical homebuyer with $440k loan could save an estimated $15,582 over five years, or roughly $260 per month, by taking out an adjustable-rate mortgage rather than a 30-year-fixed-rate mortgage.

· A 5/1 ARM is a loan in which the interest rate is fixed for the first five years and then adjusts once a year for the remainder of the loan term, which is typically 30 years.

· Borrowers can also choose ARMs in which the interest rate resets after seven years, 10 years and other durations,

· 5/1 ARMs—is one of the most popular types. By comparison, 30-year fixed mortgages allow borrowers to keep their rate for the full duration of the loan.

· The typical monthly payment for buyers who took out a 5/1 ARM are roughly 11% lower than the estimated typical payment for buyers who took out a 30-year fixed-rate mortgage.

· Adjustable-rate mortgages often come with lower interest rates, and therefore lower monthly payments, because buyers only get to lock in their mortgage rate for a certain number of years. They’ve been rising in popularity as mortgage rates have surged at their fastest pace in decades.

· ARMs are risky, as it’s challenging to predict where mortgage rates will be when the loan resets. If they’re significantly higher, it may be harder for borrowers to cover their monthly mortgage. For certain types of ARMs, borrowers may face fees or penalties if they refinance or pay off their loan early,

· For example Here is how this could look with a $440,000 loan:

· Say you have a fixed-rate 30-year mortgage at 5.5% would mean a $2,500 monthly payment and $460,000 of interest paid over life of loan.

· A 30-year ARM would be 4.75% now and then adjust to 6.75% in five years. Moving forward, the rate can go up by a maximum of 1% a year for the life of the loan with a maximum interest rate of 7.7%.

· This means an initial payment of $2,300 per month and then $2,800 in five years. In year six, if it goes to the maximum rate of 7.7% the monthly payment would be $3,000 per month. If we assume the above scenario and in year six the interest rate stays at 7.7% for the rest of the loan, then the total interest paid over the life of the loan is $600,000.

· Depending on what the difference in interest rate between an ARM to a 30 year fixed rate you may rather look at buying points, which basically means buying your rate down by 1% or maybe more. This can cost several thousand dollars, so whatever you decide to do you should do your homework and definitely talk to your mortgage broker.

There are of course many other Types of Mortgages available to borrowers:

1. Conventional loan – Best for borrowers with a good credit score

  • Can be used for a primary home, second home or investment property

  • Overall borrowing costs tend to be lower than other types of mortgages, even if interest rates are slightly higher

  • Can ask your lender to cancel private mortgage insurance (PMI) once you’ve reached 20 percent equity, or refinance to remove it

  • Can pay as little as 3 percent down on loans backed by Fannie Mae or Freddie Mac

  • Sellers can contribute to closing costs

  • Minimum FICO score of 620 or higher is often required (the same applies for refinancing)

  • Higher down payment than some government loans

  • Must have a debt-to-income (DTI) ratio of no more than 43 percent (50 percent in some instances)

  • Likely need to pay PMI if your down payment is less than 20 percent of the sales price

  • Significant documentation required to verify income, assets, down payment and employment

2. Jumbo loan – Best for borrowers with excellent credit looking to buy an expensive home

Jumbo mortgages are home loan products that fall outside FHFA borrowing limits. Jumbo loans are more common in higher-cost areas where home prices are often on the higher end.

Pros of jumbo loans

Cons of jumbo loans

  • Down payment of at least 10 percent to 20 percent required in many cases

  • A FICO score of 700 or higher usually required

  • Cannot have a DTI ratio above 45 percent

  • Must show you have significant assets in cash or savings accounts

  • Usually require more in-depth documentation to qualify

3. Government-insured loan – Best for borrowers who have lower credit scores and minimal cash for a down payment. The U.S. government isn’t a mortgage lender, but it does play a role in making homeownership accessible to more Americans.

· FHA loans – Backed by the FHA, these home loans come with competitive interest rates, and help make homeownership possible for borrowers without a large down payment or pristine credit. You’ll need a minimum FICO score of 580 to get the FHA minimum of 3.5 percent down payment.

  • USDA loans – USDA loans help moderate to low-income borrowers who meet certain income limits buy homes in rural areas. Some USDA loans do not require a down payment for eligible borrowers.

  • VA loans – VA loans provide flexible, low-interest mortgages for members of the U.S. military and their families. There’s no minimum down payment, mortgage insurance or credit score requirement, and closing costs are generally capped and may be paid by the seller.

Pros of government-insured loans

Cons of government-insured loans

  • Mandatory mortgage insurance premiums on FHA loans that cannot be canceled unless refinancing into a conventional mortgage

  • Loan limits on FHA loans are lower than conventional mortgages in most areas, limiting potential inventory to choose from

  • Borrower must live in the property

Under these programs there are Fixed-rate mortgages – These are best for borrowers who’d prefer a predictable, set monthly payment for the duration of the loan – maintain the same interest rate over the life of your loan, which means your monthly mortgage payment always stays the same. Fixed loans typically come in terms of 15 years or 30 years, although some lenders allow borrowers to pick any term between eight and 30 years. Pros of fixed-rate mortgages

  • Monthly principal and interest payments stay the same throughout the life of the loan

  • Easier to budget housing expenses from month to month

Cons of fixed-rate mortgages

  • If interest rates fall, you’ll have to refinance to get that lower rate

  • Interest rates typically higher than rates on adjustable-rate mortgages (ARMs)

Who should get a fixed-rate mortgage?

If you are planning to stay in your home for at least five to seven years, and want to avoid the potential for changes to your monthly payments, a fixed-rate mortgage is right for you.


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