A Different Kind Of Mortgage

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Today I am going to tell you about a little-known type of mortgage that goes largely ignored by consumers; not because it’s not as good as regular mortgages, but because many people don’t understand its usefulness. They are Adjustable Rate Mortgages (ARMs).

(Note:  real estate loans granted by OAS Staff FCU are only granted for properties in the United States only, and some restrictions apply.  Contact the credit union for more details)

How you repay a loan

When you take out a loan, each payment that you make gets divided: part goes to pay off

the principal –the actual amount you borrowed-, and some to pay interest, based on the rate of borrowing. Towards the beginning of the loan repayment terms, you always pay more interest than principal. That is because the amount of principal is still big, and the interest to pay gets calculated based on that current principal balance. As you pay more principal, over time, you pay less towards interest and more towards principal. Keep this fact in mind, it is important.

The basics of an ARM

Adjustable rate mortgages start by giving you, for a set given time (usually 3, 5, or 7 years), a lower rate than a conventional 30-year mortgage. Their payments are, however, calculated as if you were going to pay for 30 years. When the discount rate period ends, payments are recalculated with the new rate and over the remaining years of repayment. For example, with a 7 year arm, after the discounted period of 7 years expired, the monthly loan payment would be recalculated with the new rate, for the repayment period of 23 years.

ARMs are usually based on another standard variable rate, such as the Prime Rate. After the discounted rate expires, and based on the specifics of the loan, the interest rate might go up several percentage points.

On the other hand, a regular fixed-rate mortgage gives you the same rate over the 30 years.

Does this mean everyone should get an ARM instead of a fixed rate mortgage?

It depends on your circumstances. If there is one thing the real estate bubble taught us is that mortgage loans should be considered to their full extent, based on your honest-to-goodness ability to pay, work history, and what you expect from the home you are buying. While the interest rate can only rise just 2% per year, and a maximum of 5% during the life of the loan, any sudden jump in payment amount can surpass someone’s ability to repay the loan, depending on their circumstances.

ARMs are good for people looking to invest, who can afford to purchase a second property.

Thus they could buy a property that they might rent out for a few years when home prices are on the rise, and then resell before the mortgage rate goes up. Or maybe a fixer upper, to resell once remodeling is done.

In my opinion, though, the ideal candidates for ARMs are younger buyers, usually singles or couples without children, who look to buy a smaller, temporary property while they decide on a family home or a definite area where they want to live. Money that otherwise would be put to rent and lost can becomes an investment on which they can cash in when they decide to sell later on. Alternately, if they decide not to sell, they can refinance to a rate and term that is more convenient for them before their discount rate term expires.

Loan payment comparison

I went looked online for a mortgage calculator with payment breakdown. I found one at the Microsoft website. This is the one, or you can look online for one that does not require downloading. If you are looking for a real estate loan, this would be a handy tool to crunch some numbers ahead of time.

I requested some average loan rates for a 7 year ARM and a 30-year fixed mortgage from Cristian Calle, real estate loan officer at the credit union. Using those figures I calculated the payments and schedule for a sample $200,000 loan that starts May 1, 2014. Then I looked at how things were after 84 months with the loans, as that is when the ARM discounted rate would expire. Here’s what I got.

Case 1:

$200,000 loan  -  30 year repayment  -  4,25% fixed rate:

Monthly payment $983,88

Loan balance after 84 months: $173,097.78

Case 2:

$200,000 loan  -  30 year repayment  -  3,375% rate for the first 84 months, calculated for payments of 30 years:

Monthly payment $884,19

Loan balance after 84 months: $169,566.93

With an ARM I would pay $100 less a month, and my loan balance would be $3,500 less after paying for 7 years, if I took a 7-year ARM loan.

Case 3:

Finally, what if I wanted to pay a little more on my ARM loan each month, the $100 I saved on the payment compared to the fixed rate mortgage? In that case your loan balance after 84 months would be $160,135.96!

In conclusion

As you can see, these loans meet a different demand and provide you for savings if your circumstances are not those of a long-term buyer. This difference is good to keep in mind when considering your needs. Regardless, speak to the credit union’s real estate loan officer, Cristian Calle, so that he may help you find the loan that best meets your needs when you decide to buy.