It's Risky, But An ARM Can Get You A Bigger House - Inside Mortgages
Most people turn to adjustable-rate mortgages (ARMs) because they carry lower interest rates, and that translates into lower monthly payments. Lower interest rates also may allow you to qualify for a bigger home loan, which means you can afford a bigger house. How much bigger? Quite a bit.
First, let's look at how ARMs are structured, and at what happens when it's time to bring the word “adjustable” into play. With an ARM, the lender agrees to a lower interest rate for the first year or more of the life of the loan. Technically speaking, an ARM can be negotiated for any length of time, but the most common ones are one-, three-, and five-year loans. The shorter the time before the loan adjusts, the lower the initial interest rate. In today's market, if you could qualify for a 30-year rate of 5.5 percent, you could probably also qualify for a one-year ARM for 3.5 percent, or a three-year ARM at 4.375 percent, or 4.625 percent for a five-year loan. Once the introductory period is over, the loan goes either up or down to match the current rate, and it can adjust every year after that.
Since no one really knows what the interest rates will be next month, let alone in one, three, or five years, risk is a factor. If you are shopping for an ARM, make sure it has annual caps limiting the amount the interest can be increased at any one time -- 2.0 percentage points is common -- and a ceiling that limits how high it can go, which is often a total increase of 6.0 percentage points.
The interest rate on a 30-year loan is always going to be higher than it would be for the first five years of an ARM. How much more depends upon the 30-year rate. With the 30-year rate at 5.5 percent, you could get an ARM at 4.625 percent. Were the 30-year rate to climb to 6.0 percent, you might be able to get a five-year ARM for 5.0 percent or 4.875 percent. The higher the 30-year rate, the bigger the spread.
When interest rates are low, as they are now, there is less room for maneuvering. The savings can be measured in the thousands of dollars, in some cases in the tens of thousands, depending on the size of the loan. The point to remember is that when you qualify for a loan and a lender determines how big a payment you can afford to make, the “payment” includes both interest and principal -- but it does not include taxes and insurance.
ARMs also are structured differently than conventional loans. Let's say you have a five-year ARM on a $100,000 loan at 4.625 percent. The payments would be based on its being a conventional, 30-year loan at 4.625 percent. You would make a basic monthly payment of $514.14. At the end of those five years you would still owe $91,329.28 in principal and it is likely the loan would be adjusted.
Now let's say that the interest rate had shot up and you were now paying 6.0 percent. The loan would be recalculated so you could pay off that balance over 25 years at the new rate. This would make your basic monthly payment $588.44 -- an increase of $74.30 a month, or $991.60 a year. If you were to end up paying 8.0 percent the next year, the new, basic monthly payment would be $704.89 -- a $190.75-a-month increase.
Yet even though ARMS are risky, there are a number of reasons to choose them. Many people like ARMs because they know they will be moving before they have to face an adjustment. Others opt for ARMs because they have built-in guarantees limiting how high the interest rate can go, coupled with faith that interest rates will not climb too high. Some people use ARMs because they are the only way they can afford to buy a house -- and they hope for the best. And some people want ARMs because they can get a bigger house.
A $100,000 conventional, 30-year loan at 5.5 percent requires a basic monthly mortgage payment of $567.79. So, if you were approved for a mortgage payment of no more than $567.79 a month, $100,000 is the maximum size loan you could get at 5.5 percent. But if you got a five-year adjustable-rate mortgage at 4.625 percent, the monthly payment would be only $514.14, or enough to cover a loan of $110,435. Therefore, you could move into a home that cost $10,000 more. Of course, at the end of the five years you would still owe $100,859.52. And if the interest rate were to jump to 5.5 percent, your basic monthly payment would rise to $619.37.
People who choose this type of loan think about the amount of paid equity they will have in the home at the end of five years. With the 4.625 percent ARM, it would be $9,575.48. This does not count any added equity from increasing property values. If they had taken the 30-year $100,000 loan at 5.5 percent, the monthly payment would have given them $7,539.47 in equity or $2,036.01 less. That lower equity would also be in a home that cost $10,000 less to buy.
Finally, even though the word "adjustable" applies to the mortgage rate when you get an ARM, you can also apply it to your home-buying plans and strategy. Ask yourself: Do you want the lowest payment you can get? Or do you want to get the most house you can get? It's a choice that only you can make, and it is definitely something to think about when you go shopping for both your next mortgage and your next home.
First, let's look at how ARMs are structured, and at what happens when it's time to bring the word “adjustable” into play. With an ARM, the lender agrees to a lower interest rate for the first year or more of the life of the loan. Technically speaking, an ARM can be negotiated for any length of time, but the most common ones are one-, three-, and five-year loans. The shorter the time before the loan adjusts, the lower the initial interest rate. In today's market, if you could qualify for a 30-year rate of 5.5 percent, you could probably also qualify for a one-year ARM for 3.5 percent, or a three-year ARM at 4.375 percent, or 4.625 percent for a five-year loan. Once the introductory period is over, the loan goes either up or down to match the current rate, and it can adjust every year after that.
Since no one really knows what the interest rates will be next month, let alone in one, three, or five years, risk is a factor. If you are shopping for an ARM, make sure it has annual caps limiting the amount the interest can be increased at any one time -- 2.0 percentage points is common -- and a ceiling that limits how high it can go, which is often a total increase of 6.0 percentage points.
The interest rate on a 30-year loan is always going to be higher than it would be for the first five years of an ARM. How much more depends upon the 30-year rate. With the 30-year rate at 5.5 percent, you could get an ARM at 4.625 percent. Were the 30-year rate to climb to 6.0 percent, you might be able to get a five-year ARM for 5.0 percent or 4.875 percent. The higher the 30-year rate, the bigger the spread.
When interest rates are low, as they are now, there is less room for maneuvering. The savings can be measured in the thousands of dollars, in some cases in the tens of thousands, depending on the size of the loan. The point to remember is that when you qualify for a loan and a lender determines how big a payment you can afford to make, the “payment” includes both interest and principal -- but it does not include taxes and insurance.
ARMs also are structured differently than conventional loans. Let's say you have a five-year ARM on a $100,000 loan at 4.625 percent. The payments would be based on its being a conventional, 30-year loan at 4.625 percent. You would make a basic monthly payment of $514.14. At the end of those five years you would still owe $91,329.28 in principal and it is likely the loan would be adjusted.
Now let's say that the interest rate had shot up and you were now paying 6.0 percent. The loan would be recalculated so you could pay off that balance over 25 years at the new rate. This would make your basic monthly payment $588.44 -- an increase of $74.30 a month, or $991.60 a year. If you were to end up paying 8.0 percent the next year, the new, basic monthly payment would be $704.89 -- a $190.75-a-month increase.
Yet even though ARMS are risky, there are a number of reasons to choose them. Many people like ARMs because they know they will be moving before they have to face an adjustment. Others opt for ARMs because they have built-in guarantees limiting how high the interest rate can go, coupled with faith that interest rates will not climb too high. Some people use ARMs because they are the only way they can afford to buy a house -- and they hope for the best. And some people want ARMs because they can get a bigger house.
A $100,000 conventional, 30-year loan at 5.5 percent requires a basic monthly mortgage payment of $567.79. So, if you were approved for a mortgage payment of no more than $567.79 a month, $100,000 is the maximum size loan you could get at 5.5 percent. But if you got a five-year adjustable-rate mortgage at 4.625 percent, the monthly payment would be only $514.14, or enough to cover a loan of $110,435. Therefore, you could move into a home that cost $10,000 more. Of course, at the end of the five years you would still owe $100,859.52. And if the interest rate were to jump to 5.5 percent, your basic monthly payment would rise to $619.37.
People who choose this type of loan think about the amount of paid equity they will have in the home at the end of five years. With the 4.625 percent ARM, it would be $9,575.48. This does not count any added equity from increasing property values. If they had taken the 30-year $100,000 loan at 5.5 percent, the monthly payment would have given them $7,539.47 in equity or $2,036.01 less. That lower equity would also be in a home that cost $10,000 less to buy.
Finally, even though the word "adjustable" applies to the mortgage rate when you get an ARM, you can also apply it to your home-buying plans and strategy. Ask yourself: Do you want the lowest payment you can get? Or do you want to get the most house you can get? It's a choice that only you can make, and it is definitely something to think about when you go shopping for both your next mortgage and your next home.
posted by Kirby P at 9:56 AM
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