Q & A: To be variable or not to be?…. That is the question!
Over my years in the mortgage industry, I have walked into so many conversations that involve Adjustable Rate Mortgages (ARM), and it ceases to amaze me, the bad rap they continue to get. So if we’re going to discuss choosing an ARM over a fixed rate or vice versa, then we are going to lay down some general understandings:
1. I highly recommend you seek the knowledge and expertise from a trusted advisor that understands debt mechanisms. If you don’t have one, call me I would be happy to discuss things through.
2. ARM’s are neither good nor bad. I’m a motorcycle rider and I have always compared ARMs to motorcycles (feel free to use your own motorized vehicle if you want). People always contend that motorcycles are bad and that if you own one, it will kill you. Sitting in my garage sits a motorcycle, I can guarantee you that it won’t kill anyone sitting there… unless of course the kick stand breaks while they are crawling under it. But even then, I have never heard of that happening. It boils down to a few things for me; who sold the bike, how is the bike going to be used, how savvy is the person riding the bike? [Back to ARMS] Really, does a first time homebuyer on a set hourly wage income going to use a negative amortizing payment option ARM properly? And what was the Loan Officer who sold it to him/her thinking?
3. Fixed rate loans are neither good nor bad. I really think this is the same agreement as above. You need to understand what you’re buying and why you’re buying it in order to assess its value to your short and long term financial success.
4. The financial crisis we are in today was not caused solely by Adjustable Rate Mortgages. Although I do believe the mismanagement at several levels of the private, government and consumer sectors have had major play in this arena… to pin it on ARM’s… subprime or not…. is passing the buck.
5. Banks don’t make more money when your ARM rate goes up or less when your ARM adjusts down. They are looking to clear a margin. The margin is the difference in interest rate between the funds they have borrowed and the funds they have lent out. When rates go up or down for you, rates in turn go up or down for them.
6. Understanding key terms of an ARM are critical (index, margin, caps…..)
7. No matter what happens… you have to sleep with the decision, because you are the one living in the home and making the payments.
I’m going to take for granted that most of you reading this understand the benefits to a 30 year fixed rate mortgage. In short, it provides long term security, stabilized monthly payments, predictability and pretty close to the best tax advantage possible with home financing.
Typically the time that you expect to stay in the home is a major factor to assessing the value of an ARM. If you plan on staying for thirty years, then it makes common sense from a risk standpoint to NOT work with a 1 year adjustable rate mortgage.
But when does it start to make more sense?
Although it’s different for everyone (above # 7) it begins to make sense when your cash flow, equity position and net worth look to be considerably affected to the better by use of the ARM. Using a 5/1 ARM with 1/5 caps when you know you might live there for no more than 7 years at the worst would be an example of a time that it might be palatable. On a $150,000.00 loan with a 1 point difference in rate, that’s approximately $7,000.00 in savings worst case, but $11,000.00 best case – A cash flow difference of roughly $89 a month. But there again, can the cash flow swings be stomached on the last two years if the rate jumps both times? Remember… that worst estimate doesn’t mean it is certain to happen.
So after all of this, you are left with assessing risk. Ask yourself, “What are the chances I’m going to better my financial picture by utilizing an ARM? “
• Planning is essential. Taking extra cash flow and saving it for rainy days helps weather the short term effects of negative movement on the variable rate.
• Learn the terms inside and out for the ARM you might be considering.
• Crunch numbers.
• Ask for help when things just aren’t making sense.
• Whatever the decision, you have to sleep with your decision.
Where are you going to get the biggest bang for the buck with the least amount of risk?
About Mikal Knotek:
Knotek has been a Senior Loan Officer with Bell Mortgage since 1997 and has been a Presidents Club member since 1998. Mikal is versed in commercial finance and understands how to explain the financial implications home financing has on his client’s short and long term financial future. Mikal was also designated by Minneapolis-St Paul and Twin Cities Business Magazines as a “Super Mortgage Professional” an honor given to less than 4% of the mortgage lending community. Visit Mikal online at http://www.mjkmortgage.com/, firstname.lastname@example.org or call him direct at 952-278-8707.
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