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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