Note Buyers USA

Adjustable Rate Mortgages

Now’s the time to slay the misconceptions about adjustable rate mortgages (ARMs) that misguide many borrowers, loan reps, and realty agents. These misconceptions block you from the information you need to choose wisely. As a result, you could bypass ARMs without a second look. Or you might select an ARM for the wrong reasons.
ARMs do not necessarily present more risk than fixed-rate loans. For many people, ARMs excite fears of potential loss. If interest rates head up, you stand to lose a lot of money as your monthly payments climb above the payments that you would have made with a 30-year, fixed-rate mortgage. Or you view the ARM risk in terms of uncertainty; you wonder if you can afford the higher payments. You fear that rate hikes might wreck your budget—or even force you to quickly sell the property.
You know what? More than likely, you’ve exaggerated the risks and misinterpreted the facts.

Granted, the monthly payment on your ARM could climb above the amount of your fixed-rate monthly payment, but if you follow our advice, you can squash that possibility. Still, for the sake of argument, assume that it does. Have you really suffered a loss? Not necessarily; to calculate “loss” in this sense, you would need to total all of your interest paid compared to the amount of interest you would have paid with a fixed-rate loan. Experience shows that throughout most of the past 25 years, borrowers who chose ARMs paid less total interest for the same amounts borrowed than their 30-year fixed-rate peer group.

Regret or Loss
Human nature programs us to feel regret when hindsight reveals that our decision turned out badly. Thoughts of “woulda, coulda, shoulda” run through your mind. But that’s not the same thing as loss. That’s life. Say you buy a new Saturn in March for $15,000. You tell all your friends about the great deal you negotiated.
In April, General Motors announces a $3,000 rebate program or zero percent financing for three years. Have you suffered a loss? No, at the time you bought, you (presumably) got the best deal available. But do you kick yourself for not waiting? Do you, after the fact, concoct stories about how you felt GM would soon come out with a rebate deal, but immediate gratification overwhelmed your perceptive talents?1 Probably yes, if you’re like most people.

Fixed-Rate Borrowers Should Suffer the Same Types of Regrets
What if you pass up a one-year ARM with a 4.0 percent start rate and a 5.5 percent contract rate, no points, in favor of a 7.0 percent, one-point, 30-year fixed-rate (a trade-off that was available several years ago). Then, within the next 18 months the 30-year fixed-rate falls to 6.0 percent. At the same time, the new rate on the one-year ARM falls to 3.75 percent (T-bill index + 2.5 margin). You’re now paying hundreds of dollars more per month than you would have paid with the ARM.( You could possibly refinance, but that could cost you several thousand dollars—a loss that you would not have incurred had you selected the ARM. Of course, the ARM borrower could also refinance into that new lower rate) Do you feel the same high level of regret? Maybe not. Why?
When your ARM payment goes up, you’re cash-out-of-pocket. But if you have chosen a fixed-rate loan and interest rates fall, you do miss a chance to benefit immediately, yet suffer no cash loss. The economic effect, however, remains the same: In either instance, ARM or fixed-rate, when the market moves against your present interest rate (down for fixed-rates, up for ARMs), your monthly payments may stand higher than they otherwise would have been had you chosen differently at the time you originally obtained your mortgage.