If you’re a prospective homebuyer in New Jersey, you are probably willing to try anything and everything that may lower your monthly mortgage payment. This article reviews the pros and cons of adjustable-rate mortgages (ARMs), and I would also encourage you to Google other topics, like:
- • Temporary mortgage rate buydown
- • When to pay points
- • Mortgage rate forecasts
If you want my input on any of these topics, please give me a call at 973.453.2472 or send me an email.
Although the idea of an ARM is a great one, it isn’t usually the best choice for your home mortgage. The idea behind an ARM is that you receive a low promotional interest rate for 3, 5, 7, or 10 years, and then your rate is subject to change (up or down) after the promotional period. There are some technical details about ARMs that are important to understand if you’re thinking about pursuing an ARM mortgage loan: index, margin, floor, and ceiling.
The index of an ARM describes the current market environment and represents what it costs the mortgage lender to borrow money. One common index is the Constant Maturity Treasury (CMT) Index. The computation of this index is complex, and you can read more about it here. Another common index is the ‘prime rate,’ which is published daily in the ‘Money Rates’ column of the Wall Street Journal. The prime rate as of 5/17/2023 is 8.25%.
In order for any lender to make money by collecting payments, they need to have a profit margin. In the ARM world, the margin represents the markup between the index (cost for the lender to borrow the money) and the actual interest rate that the customer receives.
Stated another way:
Mortgage Rate = Index Rate + Margin.
The average lender margin is 2.5%. Therefore, as of 5/17/2023, the average lender using the ‘prime rate’ index would be offering customers the rate of 8.25% + 2.5% = 9.75%.
For residential mortgages, the ‘prime rate’ is typically utilized by lenders offering 2nd mortgages, and more specifically, Home Equity Lines of Credit. ARMs typically use the CMT or SOFR (Secured Overnight Financing Rate) index (more about SOFR index here).
Floor and Ceiling
Most ARMs adjust either every six months or 1 year after the initial fixed rate (promotional) period. At each adjustment, the current index rate is added to the margin to get the new interest rate. The exception to this rule is the floor rate and ceiling rate.
The floor and ceiling rates represent the lowest and highest possible rates allowed for a particular ARM product. For example, if the current ARM rate is 6.25%, then the maximum ceiling rate may be 11.25% and the floor may be 5.5%.
So when is an ARM the best financing option for my mortgage?
The answer is: when the ARM rate is substantially lower than the fixed rate, AND when you plan to sell your property or pay off your loan before the promotional rate expires.
How much lower is substantially lower?
The answer depends on your loan amount.
Here’s an example:
If you have a $200K loan amount, you will want the ARM rate to be at least 1% lower than the fixed rate. The reason is that if you will have to refinance your loan after the fixed rate period (to avoid your rate adjusting upward), you would pay $3,000 - $5,000 for that refinance. To pay this refinance cost and still be financially ‘better off’ by choosing an ARM, you will need to have saved more than $5,000 on your monthly payment by selecting an ARM. For example, if you borrowed $200K at 5.5% on a 5-year ARM (instead of 6.5% on a 30 year fixed), you would save about $7,090 over 5 years. If you had to refinance after 5 years to avoid your rate from increasing from 5.5% to 8.5%, you would need to spend $5,000. This will make the net benefit of pursuing the ARM: $7,090 - $5,000 = $2,090.
If you are borrowing $1,000,000, you may only need a 0.5% lower rate on an ARM for it to be financially beneficial vs a fixed rate mortgage.
The second half of the ‘When do I choose an ARM’ answer is ‘If you plan to sell your property or pay off your loan before the promotional rate expires.’ The reason this is important is that the ARM only saves you money if you can either refinance (to the same or lower rate) after the fixed rate period expires and/or pay off the loan (by selling or paying off the loan with cash). Most buyers don’t have certainty that they will sell their home or pay off their loan in 3, 5, 7, or even 10 years. Due to this uncertainty about future plans to sell, fixed rate loans are typically the best choice for most borrowers.
One final topic to consider is the practicality of securing an ARM with a rate that is 0.5% or 1% lower than the current fixed rate mortgage. Most of the borrowers who are concerned about saving money on their mortgage payments are first time buyers with 3%, 5%, or 10% down payment. ARMs have terrible pricing with low down payments. This means that typically the rate with ‘no points’ for an ARM is the same or higher if you have a down payment less than 30%, and therefore there is no benefit to pursuing an ARM if you have a low down payment.
However, if you have 30% or more down payment, then ARMs will have a lower rate available, especially if you are willing to pay points (extra non-refundable loan fees to ‘buy’ a lower rate).
In summary, ARMs are typically not the best choice for most borrowers, especially first-time homebuyers. The reasons are:
- • ARM pricing is not much different from fixed rate pricing for low down payment percentages.
- • ARMs have the potential to increase in rate after the promotional fixed rate period.
- • If you have to refinance out of an ARM to avoid the interest rate increase, the cost of refinancing diminishes the payment savings you received by pursuing an ARM.
- • There is no guarantee that refinancing will be possible and/or beneficial once the fixed rate period has lapsed, and you may get stuck paying a higher rate.
The are only three scenarios when an ARM is an excellent choice:
- • When you have 30% or larger down payment
- • If you are interested in paying maximum points to buy a lower-than-market rate
- • If you have the extra funds in your bank account to pay off your loan after the fixed rate period lapses (in the case that market rates increase).