ARMs and the Plan: Why We Got an Adjustable-Rate Mortgage

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I've been obsessing over whether to buy or rent an apartment over the last several months. But after renting for eight years, my wife and I finally decided that buying an apartment in New York City made sense for us.

When we started the process, I assumed that if Jenn and I did buy, we would just get a 30-year fixed rate mortgage. That's the loan type I'd always heard about -- the one whose rates are discussed in the news media, the one mentioned by friends who had bought.

Though the Fed recently said it was going to hold rates low "for some time," there's really nowhere for rates to go but up in the future. So it seemed natural to want to lock in today's attractive rates for a long period of time. On top of that, the alternative -- adjustable rate mortgages -- have gotten a lot of negative press for their role in the recent financial crisis. Their low initial interest rates lured subprime borrowers into taking out mortgages that they later found themselves unable to either refinance or repay.

After taking a long look at all of the factors and our own situation, we decided to go with a 7-year adjustable rate mortgage. That's right, we chose the much-maligned ARM -- and here's why.

It's About Time

When it comes to mortgages, the time component is the most important part of the equation. If you're buying a house that you're planning to stay in for the rest of your life, then a 30-year fixed rate loan probably makes sense.

For us, we went into the process having a strong idea that this apartment would be a "starter home," and that we'd probably want to move somewhere else in 5 to 7 years. To come up with that time frame, we walked through a lot of different "what-if" scenarios, and mapped out how those "what-ifs" would affect our apartment timing. Aside from our scenarios, we looked at industry data to confirm our logic.

According to Credit Sesame, the median number of years that the average American stays in a home has increased from 6 years to 9 years since the housing bubble burst. However, Chris Halstead of Halstead Property told us that the average term of ownership in NYC tends to be shorter than the national average."We see most customers holding on to any one apartment for an average of 5 to 7 years. This trend is most common in our entry level, and second move market."

"Because the average price of apartments in NYC is quite high, first- and even second-time homeowners tend to buy apartments that suit their immediate needs, and upgrade to larger apartments as their lives develop or their families expand."

Armed with some industry averages and our own scenarios, we looked at the 5-year, 7-year, and 10-year ARMs as well as the 30-year fixed rate loan to see what would be a good fit for us. Because we wanted to make sure we had some buffer room, we decided to forgo the 5-year ARM. Though it offered the most attractive interest rate, we wrote it off as too risky. The 10-year ARM actually had the same rate as the 30-year fixed rate loan, so we saw no point in even considering it. The 7-year ARM, on the other hand, provided us with a material interest rate benefit and matched the long end of our time horizon.

Lower Initial Cost

Compared with fixed rate loans, ARMs typically provide borrowers with a lower fixed interest rate for an initial period of time -- the length named in the loan -- after which that rate resets annually based on an interest rate index.

%VIRTUAL-article-sponsoredlinks%For us, the rate difference between a 30-year fixed rate loan and a 7-year ARM was about 1 percent. In other words, if the initial interest rate on the 7-year ARM was 3.5 percent, then the 30-year fixed rate was 4.5 percent.

Over that initial 7 year period, that 1 percent difference equates to $35,000 in additional interest on a $500,000 loan. That's a huge amount of savings that we'd be able to utilize for other household expenses, or to pay down our principal quicker.

Beyond the savings, having a lower interest rate allowed us to buy the apartment we wanted, while keeping our monthly payment (after the tax benefit) about equal to what we were paying in rent. This not only made me extremely happy, but satisfied the banks and co-op boards as well. Banks typically want to see your debt-to-income ratio below 43 percent; NYC co-op boards are much more strict and want to see a debt-to-income ratio lower than 30 percent.

Putting It All Together

In the unlikely situation that we do keep our apartment, and thus our loan beyond 7 years, our interest rate will almost certainly increase. However, there are rate caps on the ARM that prevent it from increasing too far or too fast. The interest rate can't jump by more than 2 percentage points a year in years 8 and 9, and can't rise more than 5 percentage points over the life of the loan. So, for example, if you locked in a rate of 3 percent for the first 7 years, the rate in year 8 could increase to 5 percent at most. Assuming you paid a rate of 5 percent in year 8, it could only increase to 7 percent (at most) in year 9, and no more than 8 percent beyond that.

In the end, whether it's better to get a fixed rate loan or an ARM really depends on a number of factors, with time horizon, I think, being most important. At some point along the timeline, a 30-year fixed rate loan does become more attractive than a 7-year ARM. In our case, the breakeven point was at year 10.

Since we reasoned that there was almost zero chance we would still have this apartment in 10 years, and most likely not beyond 7 years, we were comfortable with taking the risk in return for the upfront savings. Ultimately, what's most important is to try to match the length of your loan (with some buffer) with the expected time horizon of your home.

Are you currently in the market for a house? If so, are you planning to get a fixed or adjustable-rate mortgage, and how did you choose?

Roger Ma is a digital media professional, personal finance expert, and licensed real estate salesperson. He is the founder of lifelaidout, a personal finance blog that helps others identify value and save time, money, and energy in their everyday lives.

Which Is the Best Mortgage for You?
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ARMs and the Plan: Why We Got an Adjustable-Rate Mortgage

With the subprime mortgage mess unfolding all around us, there's never been a better time to make sure you make the right mortgage decision.

Of course, no single loan is best for all circumstances, but the following eight loan types work better than most when matched to your individual situation and lifestyle.

Next: For the Long Haul

Loan to consider: 30-year fixed rate

Why: Financial peace of mind can be worth the higher interest rate that won't change for three decades.

Next: Refinancing
(15-20 yrs before retiring)

Loan to consider: 15- or 20-year fixed or ARM

Why: You can retire the loan before you retire from your job. A fixed rate generally costs more than an adjustable, but will give you more certainty in budgeting. However, if ARMs are a lot cheaper and your income can handle possible payment increases, you could save with the adjustable rate.
Next: Recent Graduate
(With strong potential for increased earnings)
Loan to consider: 1-year ARM Why: Stretch your dollars with low interest rates during the years when your income is at its leanest. Your rate can go up (or down) each year, but rate caps will limit that change to a predictable amount, and your rising income should be able to handle it. Watch out for loans that cap your payment instead of your rate. They could cause your indebtedness to grow.
Next: Self-Employed

Loan to consider: No- or low-documentation loan

Why: Though you'll pay a higher interest rate, not having to produce paycheck stubs or employer references, as you would be expected to supply when applying for a traditional loan, can be a huge help to those with variable incomes.

Next: 4-5 Year Plan

Loan to consider: A 5/25 hybrid loan

Why: If you won't keep the loan longer than five years, why pay extra to lock in an interest rate for a longer period? If you do end up staying longer, you can either refinance or live with an interest rate that adjusts every year.

Next: Good Income, but ...
Loan to consider: Option ARM
Why: With these very risky loans designed for people with incomes that vary monthly, each month you have a choice of payments: the full amount needed to pay off principal and interest, an amount that covers only the interest, or an even smaller amount that doesn't even cover interest owed. Over time, however, your required payments could rise significantly if you often choose the smaller payments.
Next: Job Relocation
(With good income, savings)
Loan to consider: Interest-only
Why: While these loans can be risky for novice borrowers or those stretching to afford a home, they can be a smart tool for savvy borrowers who already have assets built up. Monthly payments are low because you're not repaying principal, so you can afford a larger loan. If you sell the home for less than you paid, however, you have to come up with the difference.
Next: Military or Veteran
Loan to consider: VA loan

Why: The U.S. Department of Veterans Affairs offers loan guarantees that allow qualified military personnel and veterans to take out mortgages for as much as $417,000 with zero down payment. In Alaska, Hawaii, Guam and the U.S. Virgin Islands, that loan amount goes up to $625,000.

Next: More on Mortgages
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