Why I picked an ARM or Adjustable Rate Mortgage

Note: This post was originally written and meant to be posted around closing on the condo. I’ve adjusted it so that it still makes sense and in hopes that my thought process helps someone else, even if I didn’t end up closing on the loan.

In the search for my mortgage lender, I compared about five local credit unions, instead of going through a mortgage broker. A lot of the rates were comparable, but when you factored in the closing costs and the total cost of payments over the first seven years, two were pretty much a wash. One is the credit union which I use for my day-to-day banking.

I made a spreadsheet comparing the closing costs (and the total upfront costs), the interest rates, the monthly payments, the total cost of the loan over 30 years (assuming no pre-payments), the total cost of the loan with $500, $1200 or $2000 in monthly pre-payments after the first year, and the total cost over the first N=1..7 years with no pre-payments.

One credit union had ridiculously high closing costs in comparison to the other one (higher origination fee by 1% (!)) by a significant amount. One credit union dealt better with my preference to emails rather than phone calls during the work day.

I ran the numbers listed above for a 30 year fixed with and without points, a 7/1 ARM with and without points, and a 5/1 ARM. The 5/1 ARM was the clear winner, with the 7/1 ARM coming in second, and the 30 year fixed far behind.

How quickly could I pay the mortgage off if I threw all of my discretionary income at it? 7-10 years. From a financial perspective, the 5/1 ARM is thus risky and the 30 year fixed unnecessarily long. The 7/1 ARM isn’t so bad though because the balance after 84 payments on the loan could be around $40,000.

It thus came down to a life decision. How long did I see myself living in this place? If I saw myself trading up or moving in 5 years, the 5/1 ARM could make sense. But I see myself wanting out of a 2 bedroom condo in about 7 years, in mid-to-late 2018. That rules out the 5/1 ARM and makes the 0.5% lower rate on the 7/1 ARM over the 30 year fixed catchy. Or, if I don’t have kids, I could see myself staying in a condo for quite awhile since I have an aversion to spending time on house maintenance, in which case, I could afford to pay off the mortgage pretty close to around the 7 year mark.

So I signed on a 7/1 ARM amortized over 30 years with an initial rate of 3.5%.

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11 thoughts on “Why I picked an ARM or Adjustable Rate Mortgage

  1. I took out a 5 year ARM on my place after doing a similar analysis when I first bought. Despite the fact that my rate has reset to an unbelievable 2 7/8, it has caused me a lot of stress along the way. I never imagined I’d be living in my place more than 5 years. You would be much safer with 7 years. Even though all has worked out I really wish I had just gone for a 30 year fixed.

    I am about to start shopping for my next mortgage, and even though we hope to have our house paid off sooner rather than later, I am not even looking at ARMs this time. I would rather have the option to keep the rate fixed for 30 years if we need it.

    When I took out my first mortgage it was in the day of no-doc, low fee bliss. If you have any tips on negotiating a mortgage in today’s world, I would love to hear them. Do you feel like some lenders are willing to negotiate on fees or is everything pretty much fixed at each institution?

    • One of my friends took out a 5 year ARM with the assumption that he would trade up within 5 years or so, but the 5 year ARM definitely seems too risky to me. I think that the 7 year ARM would cause me less stress (like you suggest), but the 10 year ARM doesn’t seem to offer a rate lower than the 30 year fixed, so I don’t think that would be worth the added risk. I’ll definitely re-evaluate when I shop for another mortgage if I still want the 7 year ARM or if I want a 30 year fixed. The rates could change between now and then, making the math different.

      If I was buying a “forever” house in which I planned to raise kids, I would definitely go with a fixed rate (at whatever year term makes the most sense) that could be afforded with the lower of the two incomes alone.

      I didn’t attempt much negotiating. I think you would have a better chance with buying a house, rather than a condo. Every lender I talked to had different requirements for condo loans: one required a maximum of 70% LTV, one gave the best rates at 75% LTV, one only required 90% LTV, but charged mortgage insurance if higher than 80% LTV. Every lender’s HOA requirements were different too… Everything seemed simpler with houses, which results in better rates and more negotiability I think since it’s less complicated for them to underwrite your loan.

      I shopped around by checking out rates and free online quotes with all the credit unions with branches in my county and then by getting more full quotes from the top 3. I liked that process better than going through a mortgage broker, but I may talk to direct mortgage lenders and a friend’s mortgage broker the next time I’m shopping since the mortgage broker did quote me 0.25% lower with comparable closing costs to what I already had. If Redfin is in your area, they have partner lenders and you could also try to get quotes from them.

      I found that every institution had _different_ fixed fees. That made comparing closing costs quite annoying. I didn’t understand how each institution quoted the COUNTY recording fees differently. Maybe that’s why some people just go through a mortgage broker, but my impression from my parents was that if I was looking at 80% LTV with a credit score in the 700s, that going through a lender myself would give me more negotiating room.

  2. My worry would be about if I had a negative income shock like a job loss (especially combined with a crash in the housing market). I’d only feel comfortable with an ARM if I had an equivalent amount of money that I could use to pay it off at any time.

    We’re currently on our third no-fee refinance… which is 20 year at 4.75… so much higher, but we’ve traded peace of mind with length for interest rate (and also it would be a point lower if we’d done a real refinance rather than no-fee).

    • Hmmm, that’s a really interesting way to look at it – having the equivalent amount of money to use to pay it off at any time. One of the calculations to believe in the 7/1 ARM over a 30 year fixed I did was that I could either pay off the entire thing within 7 years or accumulate cash savings/taxable investments equivalent to the value of the mortgage by the end of the 84 months to pay it off if I wanted to stay there longer and the rate was going to jack up a lot.

      All of that, of course, assumes my current income level with no raises, but includes the level of bonuses that I expect this year for all future years. I have six months of cash reserves for normal budget, plus I could dip into the car replacement funds as additional reserves and there are some expenses I would cut out in the case of job loss, like eating out quite as much as I do, clothes, travel, etc. So in reality, I could probably stretch my savings* to almost a year in the case of job loss. I know that my company has a lot of HR paperwork to fire people and generally there is a probation period before you’re actually let go (this is from watching people leave the company), so I would likely have some time to try and find another job…

      Trading peace of mind for interest rate makes a ton of sense when you have a family.

      *assuming that my down payment savings account was emptied because right now, I could probably live off of my savings for 3 years without dipping into my investments.

  3. Did you look at the 5/5 ARM’s at Penfed?

    I feel like a 5/5 is better than a 7/1 because you know for sure that years 6-10 will be no more than 2% higher than the starter rate…I’m not really familiar with 7/1’s, but I assume that means the rate will change every year starting with the 8th year.

    https://www.penfed.org/55-Adjustable-Rate-Mortgage/

    • Yup, with a 7/1, the rate can change every year starting with the eighth year. The 5/5 at PenFed looks cool, but their website also suggests that the maximum LTV they allow on condos is 70%, meaning 30% down, which seems crazy high of a down payment to me.

      • So the 76k you are saving will not be at least 30% down? How true is the fear that you’d lose “a ton” if indeed you needed 7 years to pay a 5/1 ARM? Run up the numbers of a 5/1 ARM over 7 years and see what the net loss would be compared to a 7/1 ARM paid in 7 years.

        • No, 76k would not be at least 30% down – there’s no way I can find a place that I want to live in for 253k. 300-400k is far more realistic. I’ll re-do the math when I’ve settled on a specific place, but I have a feeling I will end up taking a 5/1 ARM.

  4. I chose a 5.25% 30 year fixed a couple years ago when I bought my condo, but since then I’ve no cost refi’d a couple times and am now about to close on a 3.125% 7/1 ARM. I really like the ARM because it obviously gives me the lowest rate and 7 years is a ton of time to realize capital appreciation. After 7 years, I can sell, refi to a 10 or 15 year fixed or cash out refi, the options are limitless.

    • Yeah, 7 years is pretty good. I ended up going with a 5/1 ARM this time around at 3.000% and I’ll see how it works out!

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