Is your ARM about to cost you your leg?
If you have gotten a mortgage since 2002, chances are you took advantage of the often amazingly low rates offered on adjustable rate mortgages. For millions of families these were wonderful financial products and have saved many tens of thousands of dollars.
However, every party must end, and the ARM party pretty much has. Many people are going to awake this year and find out the morning after the party isn’t so fun. For most it will mean that their mortgage payments are about to increase by hundreds of dollars each month.
Nationwide it is estimated that at least 5 million adjustable rate mortgages will adjust upwards this year, and for most it is time to re-evaluate their mortgage situation. A good lender can assist you in evaluating what is happening (or likely to happen) and go through your options.
The reason that adjustable mortgages are taking such sharp increases has to do with the way mortgage rates are set. Mortgages closely follow the Treasury bond markets. This means that one-year adjustables tend to follow the yield on the one-year T- Bill. Thirty-year mortgages tend to follow the one-year note.
For the last year or so, the yield on the shorter term T-bills has exceeded the yield on the longer term 10-year note. As a result there is little difference these days between a short-term adjustable mortgage and a 30-year fixed. Indeed, some days the fixed rate has been cheaper than even a three-year fixed.
When an ARM adjusts it is tied to a specified index plus a specific margin (or markup). Typically the margin might be 2.5-3 percent over the index, although some loans can have as high as a 5 percent margin.
In addition there are caps on how high the loan can adjust to prevent catastrophic consequences for the borrower. Note there is a difference between catastrophic and really expensive and the borrower is not protected from “really expensive.”
Typically, for example, a five-year fixed-rate mortgage will have what is known as 5/2/5 caps. This means that on the fifth anniversary of the loan the rate cannot go up more than 5 percent over the start rate. After that it cannot adjust more than 2 percent per year from the previous year or the maximum of 5 percent over the life of the loan above the start rate.
Here’s an example of what can happen if you have a $350,000 mortgage that you took out five years ago at 4.75 percent tied to the one-year T-Bill plus a margin of 2.75 percent. Currently, your principal and interest payment would be $1,825 a month.
If your loan adjusted today it would go to 7.81 percent. Your remaining balance would be $320,243 which now will be amortized over 25 years at the new rate. Your payment will jump to $2,431.52, or an increase of $606. That is a 33 percent increase in what is already probably your largest bill.
By contrast, you could refinance that loan at today’s 30-year fixed rate of 5.875 percent and keep your payment at $1,894.36 a month, only a $69 per month increase.
While there would be a 1 percent origination fee of $3,202 and closing costs of about $2,400 you will recoup your closing costs in only about 10 months. If you opted for a higher rate your closing costs would be significantly reduced although your payment would be slightly higher.
Also, beware (very aware) of loans out there that promise ridiculously low rates of 1.99 percent or thereabouts. These loans have two interest rates attached to them, the rate you pay (the lower) and the rate at which interest actually accrues, which can be as high 8 percent or more.
The difference between what you pay and what you accrue is called negative amortization and is added onto your loan balance each month. Thus even though you make every payment on time, you could end up owing tens of thousands of dollars more than what you started out owing. We call these loans alligator loans, because like an alligator they will sneak up and take a pretty good bite out of you, and a lot of people don’t survive being attacked by an alligator.
Right now rates on fixed products are great, and it’s a smart move to take advantage of them and get rid of your ARM.
Chris Neuswanger is a loan officer with Macro Financial Group in Avon and may be reached at 970-748-0342. He welcomes mortgage related inquiries from local readers.