A Guide to the Annual ARM
Why should you ALWAYS get a one year ARM rather than "locking" into a 30 year fixed rate loan? The easiest answer is that you will NEVER be able to accurately predict interest rates. Did you know that Wall Street gurus are wrong over 60% of the time with their interest rate projections over a 3-5 year timeframe? What makes you think you know better than them ?
Did you know that over a five year period of time, the one year ARM has always outperformed a 30-year fixed rate loan? That statistic has held true for over 40 years. What that means is that your average interest cost for a five year period was less with a one year ARM, than with a traditional 30 year fixed-rate loan.. Let's look at the last five years and compare a LIBOR plus a 2.25% margin ARM to a 30 year fixed rate loan:
Let's assume a customer secured a 30 year fixed rate loan in October, 2001. They would have gotten a rate of 6.75% for a $200,000 loan. Now let's assume they refinanced in the summer of 2003 to a 5.5% rate and paid out $3,000 in closing costs. How much interest (and costs) would they have paid until today? $1125/month times 20 months PLUS $3000 closing costs PLUS $916/month times 40 months. A total of $62140 in interest and costs. Good thing they refinanced because if they hadn't that figure would be closer to $67,500.
Now, let's look at the one year ARM: They would have had a rate for the first year at 5.0% or paid $10,000 in interest. The second year, their interest rate would have jumped to 5.75% costing them $11,500. The third year would have been nice, they would have been at 4.5% costing them $9,000 in interest. The fourth year at 5.50% costing them $11,000. Finally, this year, their rate would have climbed to 6.75% costing them $13,500 (the inverted yield curve, while temporary, was brutal this past year). Total costs...$55,000.
Will this trend continue? Absolutely. Their rate will be set around 7% this year and that will be difficult. Inverted yield curves don't last forever, in fact, they usually precede a period of rapidly declining interest rates of 2% or more in a 6-12 month period. This means we start the cycle all over again at a sub 5% rate next year.
How about for jumbo loans? Here's where it gets even more advantageous to have a one year ARM. You see, ARMs favor big borrowers. It is possible to get a LIBOR plus 1.75% margin loan for a jumbo where the 30 year fixed has a "jumbo premium" of .25% higher to the rate.
Why don't people borrow with annual ARMs then? People always compare the annual ARM rate to their last one year period; that context is unfair. It makes sense to analyze a loan for the average holding period (3-7 years) rather than compare over a one year timeframe.
- Last edited September 17 2008
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