Not All ARMs Are “Broken”

You’ve read about how adjustable rate mortgages have wrecked the economy. You worried about it, late at night, as you lay in bed.  That mortgage lender holding the 4.875% five-year fixed ARM, you got in the Summer of 2003, just sent you a notice that it’s about to adjust upwards.  Anticipating the inevitable financial ruin, you rip open the notice from the mortgage company and…

…your “NEW” rate, for the next 12 months, is 5.86%.

Clearly, this must be a mistake- you expected 8%.  How did you dodge the bullet.

The “new” rate for an adjustable rate mortgage is determined by two components:  the index rate PLUS the margin. In the summer of 2003. most prime ARMs were pegged to the six-month LIBOR.  In August, 2008, the six-month LIBOR index was 3.11%.  The most common margin for prime loans was 2.75%.  When your rate adjustment was determined, the mortgage company checked LIBOR, added their profit (the margin) and the resulting rate was 5.86%.  Not too bad.

You’ve been stressing because you want a fixed rate mortgage but here’s the kicker.  When you bought that home, in 2003, you knew that with 2.2 children, you would be moving within 5-7 years.  Even though you’re busting at the seams today, you want to wait 2-3 years so you can sell your home at a reasonable profit.

Maybe you don’t need that 30-year fixed rate mortgage after all.  In fact, maybe the shopping you’ve been doing on the Zillow Mortgage Marketplace has been for naught.  It may be less expensive for you to NOT refinance your home loan, if you plan on moving in 2-3 years.   Let’s look at your options:

Refinance your $300,000 loan into a 6.0%, 30-year fixed rate loan, with 2% ($6,000) in closing costs.  If we count those closing costs as “interest” (and this article about APR explains why we must), the total interest you’ll pay over the next three years is about $60,000 (I’m assuming an interest-only loan).  That’s $18,000 in annual interest, times three, plus the $6,000 in loan refinance closing costs.

Or..you could just stay put.  For the next twelve months, your rate is 5.86%; you’ll pay $17,580 in interest.  Next year, your rate may adjust upwards but your annual rate caps will kick in.  In most conventional prime rate loans, that annual cap is 2%.  So, in year two, at 7.86%, you’ll pay $23,580.  Likewise, if LIBOR goes straight up, and your year three rate adusts up ANOTHER 2%, your rate will be 9.86% and you’ll pay $29,580.  Your total interest cost, for the next three years, will be $70,740.  The worst thing that could happen is that you “lose” about ten grand in interest.  Not good but that’s the worst case scenario.

Let;s assume the annual increases are just 1%.  $17,580 for the next year at 5.86%, plus $20,580 for year two at 6.86%, plus $23,580 for year three at 7.86%. $61,740; a loss of about two grand.

We can make assumptions about interest rates ad infinitum.  If you elect to move after two years, the refinance becomes the more expensive option.  In the previously cited 2% per annum hike, you STILL would have lost money had you refinanced (about $800).

I’m not suggesting that you reject that refinance offer, I’m suggesting that you deal with a mortgage originator who has specific knowledge about these matters.  A seasoned pro will immediately examine your existing ARM note, sketch these scenarios out for you, and offer them side-by-side.  Some rely on software to compile these numbers, some can sketch it on the back of a bar napkin.

Mortgages ARE about mathematics.  While we can’t accurately predict the long-term movement of interest rates nor can we accurately pick the EXACT date you move, a mortgage originator with a financial planning background will insist that you look at these numbers, based on certain assumptions,  so that you make an informed decision.

There’s a lot of fear floating around today and loan hacks LOVE fear because it sells.  We don’t get paid to convince you stay put…today.  We do, however, get paid when you borrow money to buy your next home.  The right originator DOES make a difference in your life.

September 25, 2008