NEW YORK (MainStreet) -- Think fast: If your new five-year ARM charges less interest than a 30-year fixed-rate loan, how long will the savings last?
Five years is the obvious answer, since the lower rate is guaranteed for only that long, but under today’s unusual interest rate conditions the ARM could actually save you money for at least nine years, and perhaps much longer. That makes the ARM worth considering, unless you plan to stay in your home for the long term.
The adjustable rate mortgage, in fact, could be a good choice for a short-term owner like a near-retiree who wants to use a refinancing to save money before moving on in a few years.
As we’ve reported before, the five-year ARM has occupied a sweet spot for some time. The case is even stronger now that interest rates have dropped another notch.
Currently, the five-year ARM averages a mere 2.741%, compared to 4.5% for 30-year, fixed-rate mortgages. (The three-year ARM is a tad cheaper than the five-year version, at 2.6%, but the three-year rate guarantee is substantially less attractive, offsetting that minor savings.)
Anyone planning to keep a mortgage for 30 years would probably do best with a 30-year fixed loan, which would lock in today’s low rate for the whole term. You’d never have to worry that your monthly payments would go up. With an ARM, the rate is adjusted annually after the initial term ends, so there’s a chance you could eventually pay more than with the fixed loan.
But let’s look at some actual numbers, using the BankingMyWay ARM vs. Fixed Rate Mortgage Calculator and the Adjustable Rate Mortgage Calculator.
For every $100,000 borrowed, the five-year ARM at 2.741% would charge $408 a month, while the 30-year fixed loan at 4.5% would charge $507 in monthly payments. The ARM would be $5,940 cheaper after the first five years.
Many ARMs limit annual adjustments to 2 percentage points and lifetime changes to 6 percentage points over the original rate. So let’s assume the ARM rose the maximum, to 4.741% for year six, 6.741% for year seven and 8.741% for years eight-30.
Using the two calculators and doing some extra math shows that it would take nine years before the total paid on the ARM exceeded the total paid on the fixed loan. That’s because there would be substantial savings for the first five years, while the two loans would charge about the same in year six. After that, the ARM would cost more, but it would take three years for the higher costs to wipe out the initial savings.
Keep in mind this is the worst case, assuming maximum rate increases as soon as they are allowed. If rates rose more slowly, the ARM would be cheaper for longer.
Before opting for an ARM, though, be sure to know all the details: What is the initial interest rate? What are the annual and lifetime rate caps? How often is the rate reset once the initial period ends? What index is used to set the rate, and what is the “margin” – the number of percentage points added to the index to calculate the new rate?
If you are refinancing, the fees could easily tip the balance in choosing one loan over another, especially if you will keep the home for only five or six years. The shorter the period, the more damage fees do to any savings realized from reducing the loan rate.