Why Buyers and Refinancers Should Consider a 5/1 ARM Again
Right now, due to the problems we had with unsustainable loans, nobody wants to consider anything but a thirty year fixed rate loan. I understand why, especially as I've been preaching the dangers of things like short term adjustable interest only loans and negative amortization loans here for almost three years now. The trick is one of balance. The negative amortization loan not only has a higher interest rate than other loans (aka cost of money) but you're adding to the balance you owe every month. This has compound interest working against you. If this were not the case, you could afford a better loan (there are no worse ones). For such things as an interest only 2/28, once again you're setting yourself up with a loan that you cannot afford and a short time during which you need to be able to refinance. The balance of that interest only 2/28 may not be growing, but it isn't going down much either. In only two years, you're going to not only need to refinance it, but almost certainly roll a bunch of closing costs into your balance as well. Suppose rates are higher? Suppose prices are lower? These twin facts describe the situation lots of folks are in right now, and my article on Refinancing When You're Upside Down on the Mortgage is one of my most popular pieces of search engine bait, despite the fact that it is very much in the way of hoping you can make something a little less bad out of a horrible situation. Two years in real estate is fairly short term. Considering a two year window, I'm more certain today than at any time in the last ten years that property values (at least local to me) will be significantly higher two years from now (at least 10%), but confidence in that prediction is only in the 90 to 95% range. Two years just isn't enough time. Like when I was a financial advisor. The market is up in about 72% of all 1 year periods, and a higher percentage of two year periods (I remember 85%, but I'm not certain of that). But over a ten year period, it was a practically sure bet, historically, that the market would be up, and up significantly. The same thing applies to real estate. "Time in" is so much more important than "timing" that they don't even play in the same league.
When you get out to five years, I'm as certain as possible that my local market, at least, is going to be up and up significantly. Considering the state of most markets, this is a very reasonable bet. For that matter, it's pretty reasonable at any time, as five years is enough for sentiment of the moment to be outweighed by fundamental facts of the market. Furthermore, most people get at least one substantial raise (or a series of smaller ones) over a five year period, increasing what they can afford. More importantly, in five years with a fully amortized loan, you'll chop some significant money off the balance (about 7% for most mortgages out there), just by making the regular minimum payments. My point is this: you have a smaller balance on a property that is worth more. Your equity situation has improved, and by enough that unless you take significant cash out in one way or another, you're in a strictly improved situation.
What are you giving up by accepting a 5/1 instead of a thirty year fixed rate loan? The answer is twenty five years worth of insurance that your rate won't change at the end of your loan, which most borrowers never use anyway. The median time to refinance or sell a property was about 28 months last time I checked (for a while it was down to sixteen months). That's fifty percent above, fifty below. Add another 28 months, and before five years is up, at least seventy five percent of everybody has refinanced or sold. Question: How much good did that extra 25 years of insurance that the rate wouldn't change do these people? Answer: Absolutely none. They let the lender off the hook before that part of the guarantee began.
Let's look at some numbers that were available today. Full documentation, A paper loans, rate/term refinance between 75 and 80% loan to value ratio, with a credit score of 720 (national median). They'll be at least a little bit different before this is published, but useful for illustrative purposes.
Now the loan request that started this all off was a $600,000 loan. Here in San Diego, that's less than the temporary Conforming limits (aka Jumbo Conforming, a phrase that makes about as much sense as plastic glass),
|30F Rate||30F Cost||5/1 rate||5/1 Cost|
(Making certain I emphasize once again the tradeoff between rate and cost for real estate loans)
So, for less than the cost of a 30 year fixed at 5.875%, these clients could have a 5/1 ARM at 5.25%. For a $600,000 loan - almost to what was called Super Jumbo territory a few months ago. the 30 year fixed costs roughly $14,500 in total costs, the payment is $3635, and interest is about $3009 the first month, assuming all costs are rolled into the loan. The 5/1 costs about $12,700 grand total, the payment is $3386 ($250 less!) and interest is $2686 ($325 less!). You pay the balance down to $556,000 over 5 years if you just make the minimum payment on the 5/1, as opposed to $570,000 if you make that higher minimum payment on the 30 year fixed rate loan. And if you happen to be the sort who makes that payment they could make on the thirty year fixed rate loan, but chose the 5/1 instead, your balance will be down to $547,000. Under such circumstances, even if you refinanced that 5/1 at the same cost, you'll be over $10,000 better off than some hypothetical twin brother who chose the 30 year fixed, even if he didn't refinance which the odds are at least 3:1 against. Given consumer habits in this country, that thirty year fixed looks like a losing bet to me at today's rates.
The same numbers apply just as strongly at conforming rates:
|30F Rate||30F Cost||5/1 Rate||5/1 Cost|
The difference between the thirty year fixed and the 5/1 narrows appreciably at the lower cost end of the spectrum. But it's a far cry from the days of last year when sometimes that thirty year fixed rate loan was actually less expensive for the same rate.
Some people are likely to ask about varying periods of ARM. What about a 3/1, for an even lower rate? Ladies and gentlemen, those were actually more expensive than 5/1s today, and even when rates are more normal, the differential is usually less than an eighth of a percent, while you're cutting off 40% of your fixed period guarantee - the period that lets you make all that lovely profit? As for the 7/1 and 10/1, they were actually more expensive than the thirty year fixed today, and even when rates are more normal, there's typically more difference between them and the 5/1 than there is between 3/1 and 5/1 - plus you're getting well past the territory where reasonable fractions of the populace keep their loans without refinancing. You're paying for insurance you're extremely unlikely to need, and hybrid ARM rates are much more stable than rates for thirty year fixed rate loans.
Hybrid ARMs aren't for everyone. If you're going to obsess about your expiring fixed term every night for five years, the difference in daily interest works out to about $10 per night, even for our example with the $600,000 mortgage. My family being able to sleep well is worth $10 per night to me, and I presume it is to you, as well. There is an element of risk here, and there's no pretending there isn't. A very small risk that real estate and loan markets go completely weird in violation of all historical precedent for the next five years, and those choosing the 5/1 are somehow stuck with needing to refinance in a worse situation than when they started in. But I've been saving myself lots of money with the 5/1 for fifteen years now, in all sorts of markets. Why shouldn't I mention it to other people, including my clients?
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