When Should You Consider an ARM?

This is a follow up to the comments that I received in my post, How Dangerous are ARMs?  Obviously, these loans have been around for a long time, and have gained popularity in recent years.  So, they must be appropriate for some, right?  Or are all these people just suckers?

Admittedly, there are times in which ARMs are appropriate.  They are much more limited than most lenders would have you believe, but they exist.  Let's look at the reasons a lender would recommend an ARM or an Interest Only ARM with my responses following.

1. If you are planning on moving within five years, your payments will be lower and you will pay less total interest by financing with an ARM or an Interest Only ARM.

   My response: if you are planning on moving within five years, maybe this is not the time to buy.  I realize that many people made out well over the last few years by being a short term holder of real estate, but that's not the norm.  Even if the Realtor pundits are correct that there will not be a housing bubble bursting, rather a "soft landing" in which prices continue to climb at moderate historic rates, the interest expense, transaction expenses, and higher overall cost of buying over renting for a short period do not make sense without higher rates of appreciation.

2. If you desire a lower monthly payment, comfortable with knowing that it could increase in the future.

   My response:  Now why would you be comfortable with knowing that your monthly mortgage payment may be increasing?  What kind of maniac is cool with that?  Three types.  Those who plan to pay off the mortgage before the interest rate has a chance to adjust, those who plan to sell their house and "move up" before the rate adjusts, and those who are currently lower income, but believe that their income will increase significantly by then.  Everyone else is just fooling themselves.  Seriously, if you know that your payment could go up in five years, why would you take the deal?  Only if you think you will no longer be paying this loan, or you think you can handle the higher future payments.

   Now, if you fall in the first category, cool.  But only if you truly have the means and intention of paying this mortgage off before it adjusts.  If you are among those who believe you will "build some equity" and sell the house in about five years, before the rate adjusts, that's a mighty gamble you are taking.  I don't advise it.  And if you are among the upwardly mobile who believe that their income is sure to rise significantly.  Well, congratulations to you, but how sure are you?  You're a resident in Med school?  Sure, your income is going to spike in a couple of years.  But you're an associate at a law firm expecting to make partner?  How sure are you?  I say wait.  What's the damn hurry?  When you start making the big bucks, then buy the big house.  Until then live within the means that you currently have, not what you expect to maybe have someday in the probably not so distant future.

3. You plan to invest the difference between the 30 year fixed payment and the Interest Only, making a lump sum payment to your loan before it adjusts.

   My response:  Really?  Maybe when there's a larger spread between fixed and ARM rates.  But right now, with the spread less than 20 basis points on average?  All you are banking is the portion that should go to payment of principal.  So, there are two questions.  First, can you conservatively earn a return higher than the rate on your mortgage?  Second, do believe your rate will not adjust higher in five years?  You should easily answer yes to both.  If not, don't do this.  I amended my earlier spreadsheet to allow for this consideration.  If you invest the nearly $500 difference between the 30 year fixed payment and the 5/1 ARM interest only payment at 5.5% (high end of current t-bill/CD rates), you will accumulate a total of $33,232 at the end of five years.  If you dump that into your loan, you will reduce the balance to about $366k, which is about $6k lower than it would be at this point in time with the 30 year fixed.  However, there are two problems.  I did not include the impact of taxes on your "invest the difference" earnings.  You would have less.  Also, your 5/1 ARM Interest Only is not only about to amortize, but the rate is about to adjust.  If we stay with our earlier example and assume that it increases only 1.5%, this will not work out in your favor.  At then end of the full 30 years, you will have paid almost $80k more in interest by doing this instead of the 30 year fixed from the beginning.

So, when is an ARM truly appropriate?

In different times, when there is a larger spread between the fixed and adjustable rates maybe.  Also, when we are in a period of falling, rather than rising rates.  Right now?  Neither seems to be the case.

As Bob will tell you, Mortgage brokers will tell you that "sophisticated investors" leverage their wealth by using Interest Only or Negative Amortization Option ARMs, rather than tying up their wealth in their house.  I disagree.  Don't leverage your house to become an investor.  If you don't have any money left for investing after paying your fully amortized mortgage, you bought a house you cannot afford.

Comments

[Jill]

I have an ARM, got one 8/2005. I plan on moving in 5-7 years, will have a substantial increase in income, and the place is not a SFH, but a townhouse so I dream of a townhouse. I got a substantial rate discount about 1% less, so it's worth the risk.