Sunday, May 3, 2009

Mortgage Alert: a Hybrid ARM Could Save You Money

Buyers or those refinancing should consider getting a hybrid ARM (adjustable rate mortgage) because of low interest rates and their potential to save you money in the long run. 30-year fixed conforming loan rates are about 5%; 5- or 7-year hybrid ARM rates are about 4%.

These hybrid ARMS are fixed for five or seven years and then adjust annually (either up or down) based on market rates at the time. The increases have an annual increase cap (typically 2%) and a maximum life-time cap (typically 6%).

The negative reputation of teaser-rate, negative amortization, and pay-option ARM loans has caused buyers or those refinancing to shun anything but a “vanilla” 30-year fixed loan. In these uncertain times, many prefer to lock in a low rate for a predictable period of time.

But the reality is, a 5- or 7-year period is an eternity to many Los Angeles residents, who move up, down or out. The breakeven point, even in the most extreme scenario, may be 10 years.

Let's see how a 7/1 ARM plays out over time for a $250,000 mortgage, using a 1 percentage point difference between a 30-year fixed-rate loan at 5% and the adjustable loan at 4%. The difference between the monthly payments to principal and interest for the two mortgages is $148 -- $1,194 for the ARM versus $1,342 for the fixed-rate mortgage. Over a year's time, the savings is $1,776. And over the seven-year period the savings is $12,432.

The next question is, how long will it take to give back that money once the loan switches to a one-year adjustable? Let's consider a worst-case scenario: Say on the loan's eighth anniversary, the rate jumps the maximum allowable 2 percentage points, to 6%. That means the payment will rise to $1,499. That's a bump of $305 a month.

Over a year's time, that's $3,660 extra out of your pocket. But you're still ahead by $8,772 ($12,432 less $3,660).

Now say that in the ninth year, the rate jumps again by the 2-point maximum, to 8%. In that case, your payment this year will leap by $335, to $1,834, and your annual cost over and above your original payment will be $7,680. But again, you're still ahead, albeit by this time the savings is just $1,092 ($12,432 less $7,680 less $3,660).

It's not until early in the 10th year that you start giving back what you saved over the first nine years.

[Los Angeles Times]