So, you’re worried about your adjustable rate mortgage (ARM) going up after the initial fixed rate period, right? Don’t sweat it! There’s a cap on how much your ARM can increase, which means you won’t end up paying an arm and a leg. This cap helps you plan for the future without any nasty surprises.
Let me give you an example from my own experience. I took out a 5/1 ARM, and I firmly believe it’s a smarter choice than a 30-year fixed rate mortgage if you want to save some cash.
Why? Well, interest rates and mortgage rates have been on a downward trend since the 80s. Sure, there might be short periods of high inflation, but thanks to things like technology and a more connected world, I reckon interest rates will stay low for the rest of our lives. Paying more for your mortgage than you need to just doesn’t make sense.
Now, let’s talk about my own ARM. Back in 2014, I bought a fixer-upper in San Francisco for $1,250,000. I put down 20% and took out a $992,000 5/1 ARM. I could have put down more, but with a mortgage rate of only 2.5%, I decided to borrow more and invest the difference.
The 2.5% 5/1 ARM was based on the one year LIBOR rate plus a 2.25% margin, minus a 0.25% discount for being a good customer. The LIBOR rate is the average interest rate at which leading banks borrow funds from other banks in the London market. It’s a global benchmark for short-term interest rates.
Now, you might be thinking I should have gone for a 30-year fixed rate instead. But I believe we’re going to be in a low interest rate environment for the rest of our lives, so paying 0.85% – 1.25% more for a 30-year fixed rate seemed like a waste of money to me.
Plus, the average homeownership duration in America is only around eight years. So, it might make more sense to consider a 10/1 ARM to match durations.
In my case, I planned to either sell my home within 10 years to buy a nicer home in Hawaii or pay off the mortgage during this time frame. So, taking out a 5/1 ARM seemed worth the risk to me.
At one point, the LIBOR rose to about 3%. Based on a net 2% margin, this would mean my ARM could potentially reset to 5.25%. But even if I end up paying 5% for the next five years, my average mortgage rate over a 10 year period would still be 3.75%, which is pretty much in line with the rate I would have gotten if I just locked in a 30-year fixed rate mortgage back in 2014.
But here’s the kicker: with the money saved from not paying a 30-year fixed mortgage and the $100,000+ less in downpayment, I invested the difference and earned a ~12% return on average from 2014 – 2022 because the stock market went up.
Now, let’s talk about what happens when my ARM resets. I got a letter saying that my rate would only go up from 2.5% to 4.5% because under the terms of my mortgage, my ARM can only reset by at most 2% after the initial 5-year fixed rate of 2.5% is up. This is pretty standard among ARM loans.
ARM loans also generally have a maximum mortgage interest rate they can charge for the life of your loan. In my case, that maximum is 7.5%, but I don’t think we’ll ever get there.
After one full year at 4.5%, my bank can raise my ARM by another 2%, bringing my mortgage rate up to 6.5% for year seven. But I doubt rates will keep on surging higher as the global economy slows.
In fact, before my five-year term ran out, I refinanced my 5/1 ARM into a 7/1 ARM at 2.625% with no fees in 2019. It was a tough refinance, but I’m glad I did it.
In 2020, I bought a new primary residence and rented out my old house. I’m glad I refinanced my mortgage in 2019 because if I had waited until after I rented out my property, the mortgage rate would be at least 0.5% higher for rental properties. So, always refinance before renting out your property to get the best rate.
Even though my mortgage rate increased from 2.5% to 4.5%, my monthly payment only increased from $3,919.60 to $4,079.33, a mere 4% rise. This is because we’ve paid down 32% of our loan in 4.5 years.
I also followed a disciplined approach to paying down ARM principal and investing. I used 25% of my free cash flow to pay down debt and the other 75% to invest.
If I had taken out a 30-year fixed mortgage for 3.625%, I wouldn’t have been able to experience interest-free living.
So, don’t be scared of an adjustable rate mortgage increase. Rates likely won’t increase or increase by much. If mortgage rates do, you can always pay down principal or refinance to another reasonable rate.
In summary, match the duration of your mortgage’s fixed duration with the estimated ownership duration or the length of time you estimate it will take to pay off the mortgage. Paying for a 30-year fixed rate mortgage might provide you more peace of mind, but you’re likely overpaying for that peace of mind. Read the terms of your ARM loan carefully and figure out what is the maximum interest rate increase during the first reset and what is the lifetime interest rate cap. Try to make extra payments during your ARM’s fixed rate period to relieve potential interest rate pressure during the reset. And don’t borrow more than you can comfortably afford.
