Adjustable rate mortgages aren’t very popular with folks seeking new loans these days, since they don’t offer much upfront savings. But if you’re thinking of getting rid of an ARM you already have, keep in mind a benefit often overlooked: making extra principal payments on an ARM brings results much quicker than it does on a standard, fixed rate mortgage.
With a fixed loan, extra principal payments let you pay the debt off years early, but the monthly payments stay the same as when the loan was first issued. Make an extra principal payment on an ARM, however, and the required monthly payment will be reduced next time the loan resets, usually every 12 months.
With both types of loans, pre-payments reduce the total interest paid over the years. Getting that benefit right away, with an ARM, reduces your cost of living, freeing money for other purposes and making life easier if your income drops.
An ARM payment is recalculated on the annual reset date by applying the new interest rate to the remaining years and principal – the amount still owed. It’s as if a new mortgage were being issued.
Imagine that last year you’d gone to Wells Fargo (Stock Quote: WFC), Bank of America (Stock Quote: BAC) or Citibank (Stock Quote: C), and taken out a $200,000 30-year ARM that charged 6 percent. The monthly payment would be $1,199, according to Banking MyWay’s mortgage rate calculator. Over the past year, your payments would have reduced the outstanding principal to $197,544.
Now suppose you’d had a $50,000 windfall and used it to pay down the debt before the loan had its annual reset today. If the interest rate did not change, the next 12 months’ payments would be figured by applying 6 percent to $147,544 for 29 years. The new payment would be $896, compared to $1,199 if you hadn’t made that big payment. You can see what mortgage rates are available in your area by entering your zipcode at BankingMyWay.
If you don’t have a big sum, you can gradually reduce your required monthly payment with smaller pre-payments – a couple of hundred dollars a month, for instance. As the required payment shrinks, you be able to afford bigger pre-payments, and the benefit would snowball.
This unique feature is just one factor in evaluating ARMs. Right now, new ARMs that adjust annually charge an average of 4.91 percent the first year, while fixed-rate loans average 5.31 percent according to our mortgage rate survey. As a rule of thumb, an ARM needs to start out at least two percentage points lower than a fixed rate loan to be attractive – offering enough up-front saving to justify the risk the ARM rate will someday go higher than you’d have paid on a fixed loan.
So it may not make sense to take out a new ARM today. But if you already have one, making extra principal payments can be a good way to reduce interest costs over the years. Keeping the ARM might be the best option given the heavy fees in refinancing to a loan with a fixed rate.
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