Is it time to consider an Adjustable Rate Mortgage?

I have a confession to make: I have never used a 30 year fixed rate mortgage in 20 years of owning homes in the US. And my jumbo mortgage, which is based on 1 year LIBOR, has just reset to 3% and would be at the same rate today as the 1 year LIBOR rate has not moved over the last month.

Adjustable Rate Mortgages (ARMs) got a bad reputation because of the shenanigans of unscrupulous lenders and brokers in the boom/bubble. And I strongly believe that these people – starting at the top – should be incarcerated and the key thrown away. On an, of course, completely unrelated topic read this article alleging that Bank of America encouraged their employees to lie to home owners.

Conventional ARMs, however, for those who understand them, are a perfectly feasible financing option. Bear in mind that the average time that a mortgage is held before the house is sold or the loan refinanced is believed to be about 7 years.

According to Freddie Mac’s weekly survey, the average rate, nationally, on a 30 year fixed rate mortgage this week was 4.46%, while that on a 5/1 ARM (meaning that the rate is fixed for 5 years and then resets each year thereafter) was 3.08%.

Now I want to make this simple, so use these numbers as a rough basis on which to work.

Over 5 years, paying 4.46% p.a. makes cumulative payments of 22.3%. At 3.08% the total is 15.4%. So there is a “saving” of 6.9%. Now ARMs adjust based on a certain index but generally cannot increase by more than 2% each year. Let’s assume that the rate goes up the maximum 2% in each of years 6 and 7. The chart below shows the cumulative interest paid:

Source: Freddie Mac; Oliver Reports

Source: Freddie Mac; Oliver Reports

What this means is that even if the rate in years 6 and 7 increased by the maximum each year, interest paid over the average  7 year mortgage life would still be significantly less on an ARM than on a 30 year fixed,.

Again, this is very simplistic, not taking into account matters like principal reduction and tax deduction, but it’s the way I start my analysis. And it’s the reason I have never taken a 30 year fixed loan.

You are the only person who knows your life plan and risk tolerance, but an ARM may be an option you want to discuss with your financial advisor.