When I first dove into the wonderful world of mortgage loans as we bought our first home, the adjustable rate mortgage, or ARM, was not even something I considered. I vaguely remember associating ARM’s with the 2008 housing collapse and all the craziness around lending that was happening at that time. I also remember most of the financial blogs and advice I read at those times only talked about fixed rate mortgages.
So I went ahead and got a fixed rate mortgage. I also ended up paying origination fees and costs that I definitely should not have paid, and would not have paid, had I known about no closing cost options at the time.
Soon after I closed on my mortgage for our first house in 2011, I started digging more into mortgage loans and realized that not only was it easy to refinance, if I did it with a no closing cost lender it would actually be free. Around that time I found a great article from The Finance Buff describing his process of “stepping down” the interest rate ladder as rates fell using zero closing cost mortgages.
After I got over feeling like an idiot for paying all the fees I did for my loan, I immediately started the process refinancing with my favorite no closing cost lender in Virginia, CapCenter. The process was pretty easy and I ended up dropping my rate from 4.250% for a 15-year fixed mortgage to 3.750%, for free. I was officially hooked and started going deeper down the rabbit hole of home mortgages.
Interest rates kept dropping, and a few months later I did another free refinance to drop my rate down to 3.375% for a 15 year mortgage. This is the point where my friends and family started to think I was crazy for having 3 different loans in less than a year. I wasn’t done yet – as rates kept dropping I kept digging and learning more about how to optimize our home loan.
At this point I had learned more about when and where it could be valuable to use adjustable rate mortgages, and I also found out (on the bogleheads forums, a great site that sucked away a lot of my time but taught me tons about investing and other topics like mortgages) about a company that had a unique ARM option – Pentagon Federal Credit Union. They have a product called the 5/5 ARM. But before I explain that, let’s step back and talk about the different types of mortgages.
Fixed Rate Mortgages. This is what most people end up getting. The typical terms are 30 years, 20 years, 15 years and 10 years. The shorter the term, the lower the rate you can get, but also the higher the monthly payment. The benefit of these mortgages is that you can lock in your interest rate for a loooong time. So when interest rates are low like they have been the past few years, they are appealing and can be quite valuable. HOWEVER…
The secret about fixed rate mortgages that lenders know but we consumers often forget is that almost noone actually lives in the same house for 30, 20, 15 or even 10 years. In fact, on average we Americans move every 6-9 years (link). So while it’s awesome to lock in a super low rate on a 30-year fixed mortgage, when you move you can’t take the mortgage with you. It’s much more likely that you’ll get less than 10 years’ value out of that mortgage.
Adjustable Rate Mortgages. As I mentioned before, these always had a bad reputation for me, but as I learned more about them, I realized they can be a powerful tool for people who understand the risks. Adjustable Rate Mortgages, or ARMs, usually have names like 3/1, 5/1 or 7/1. Usually the first number (3,5 or 7) is the fixed term – this is the amount of time where the interest rate stays the same. So a 5/1 ARM at 2.500% will have a rate of 2.500% for 5 years, guaranteed. The second number (the 1) is how often the rate can reset after the initial fixed term. Also, ARM’s are typically 30 year mortgages.
The reason people shy away from ARM’s is because of that unknown of the rate reset. But if you look at the data on how long people stay in their homes, it’s actually pretty easy to get an ARM that will likely match more closely with how long you use the mortgage. Also, ARM’s almost always have the lowest rate available, often signficantly lower than fixed rate mortgages. The rates are lower because ARMs are less risky for lenders as they can raise rates if interest rates go up and they are not locked into a low rate for a long period of time.
Also, it’s important to note that rates can actually reset up OR down, and then can usually only reset once per year, and when they do reset there is a max % increase or decrease each time. There is also typically a maximum interest rate % for the life of the loan. A typical 5/1 30-year ARM may have a max % increase of 2%, with a cap of 5% above the starting rate. So if you get a 5/1 ARM at 2.500%, the worst case would look like this:
- Years 1-5: 2.500%
- Year 6: 4.500%
- Year 7: 6.500%
- Years 8 – 30: 7.500%
In my case with PenFed, they offered a super cool 5/5 ARM, which was a 30 year loan that could reset after 5 years, but ONLY reset once every 5 years instead of every year. So for my loan, which was 2.500% (and included credits that ended up paying me at closing), the worst case was:
- Years 1-5: 2.500%
- Years 6-10: 4.500%
- Years 11 – 15: 6.500%
- Years 16 – 30: 7.500%
In reality, we were ahead of the average and moved out of our first home after ~5 years, and a little over 3 years with the 5/5 ARM. So I never paid above the 2.500%.
So what did all this refinancing actually save me? Let’s run the numbers. I’m going to round things to make the calculations easier, and I’ll keep the original loan for the first year because the 5/5 ARM at 2.500% wasn’t available at that time (interest rates were higher and kept dropping).
As you can see from the above chart, this simple move to switch to an ARM saved me close to $9,000 over four years – and switching actually PAID me about $1,500 at closing, so the savings was actually ~$10,500. Another benefit is that I had much better cashflow after switching. My monthly payment (principal and interest) went from $1,264/month to $631/month.
Now, it’s important to note that the spread between a 15 year fixed an an ARM is not usually this great. I refinanced after a year of having fixed rate mortgates – all the while interest rates were going down across the board. But, you will almost always be able to lower your rate by switching from a fixed rate to an adjustable rate.
This strategy isn’t without risks, and it isn’t for everyone. If you know that rates are as low as they will ever be, and you know that you will not move for the length of your loan term, it makes the most sense to get a fixed rate mortgage for how long you’ll live in the house. The problem is that it’s not possible to know that rates are at their bottom, and it’s also very difficult to predict how long you’ll actually live in your house. The statistics show that it’s on average between 6 and 9 years.
In my next post, I’ll explain how I took the ARM strategy even further with our second home, and how we’re managing the risks associated with our ARM.
What do you think about adjustable rate mortgages? Let me know in the comments.