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By G. Steven Bray
Last time, we examined the risk of payment shock with an adjustable rate mortgage, or ARM, and asked the question why would you consider an ARM?
The answer is to lower your total interest charges. Assuming the rate increases by the maximum amount each year, at the end of 7 years, you’d have paid $57k in interest and have a loan balance of almost $213k with the ARM. With a 30y fixed-rate loan, you’d have paid $70k in interest and have a loan balance of more than $216k. With the ARM, you’d have saved $13k in interest and have about $3500 more equity in your home. In fact, the ARM looks better until sometime in the 9th year.
Thus, the number one reason to use an ARM is you expect to pay off the loan while you’re in the money, by the 9th year in our example. And our example assumes that rates will rise by the maximum amount each year. If rates don’t rise that severely, the ARM will be in the money for a longer period of time.
However, it’s important to remember that even though you’re saving money, if the payment starts rising, it may crimp your style. You may have become accustomed to a lower payment, and your household budget may not allow for the 20% rise that could come with the first adjustment.
If you’re considering an ARM only because the lower payment will help you make ends meet, I encourage you to reassess. Even if the index rate doesn’t increase from today’s level, your payment would rise at the end of 5 years, and the risk of a substantial rise is very real.