When it comes to adjustable rate mortgages (ARMs), many people worry about how high their rates might climb after the initial fixed-rate period ends. However, there are caps in place to prevent the rates from skyrocketing, making it easier for homeowners to plan their finances.
Here’s a breakdown of how ARMs work, using my own 5/1 ARM as an example. In 2014, I bought a fixer-upper in San Francisco for $1.25 million and opted for a 5/1 ARM with a starting rate of 2.5%. This rate was based on the one-year LIBOR plus a 2.25% margin, minus a 0.25% discount for being a loyal customer.
The LIBOR (London Interbank Offered Rate) is a benchmark rate that some of the world’s leading banks charge each other for short-term loans. It plays a significant role in determining the interest rates for ARMs.
Given my firm belief that we will continue to see low interest rates due to advancements in technology and global economic integration, I felt that the higher rates of a 30-year fixed mortgage were unnecessary. The average duration that people hold onto a mortgage in the U.S. is about eight years, so an ARM can often be more cost-effective.
For example, even when the LIBOR rose to around 3%, the terms of my ARM capped the maximum increase at 2%, making my new rate about 4.5%. Over ten years, this worked out to an average rate of about 3.75%, which is competitive with the rates of 30-year fixed mortgages available at the time.
Moreover, by saving on mortgage payments, I was able to invest the difference, earning an average return of 12% from 2014 to 2022. This significantly offset the cost of the mortgage.
It’s important to note that ARMs usually have a maximum rate cap for the life of the loan, protecting borrowers from extreme increases. For my mortgage, the cap is 7.5%, which we are unlikely to reach. Despite a potential increase to 6.5% in the seventh year, economic conditions and interest trends suggest rates might decrease again.
Before my initial five-year term ended, I refinanced to a 7/1 ARM at an even lower rate, taking advantage of no fees and locking in a better rate before renting out my property, which would have led to a higher rate.
Paying down the principal also helps manage increases in payments once the ARM resets. Even with an 80% increase in the rate from 2.5% to 4.5%, my monthly payment only rose by about 4%, thanks to significant principal reduction over the years.
For those considering an ARM, it’s crucial to match the fixed-rate duration of the mortgage to your expected ownership duration and to read the loan terms carefully. Knowing the maximum possible rate increase and the lifetime cap can help you assess the risk and make informed decisions.
While opting for a 30-year fixed mortgage might seem like a safer bet, it often results in higher costs over time if you don’t plan to stay in your home for the full term. ARMs can offer significant savings and flexibility, especially in a declining rate environment.
Lastly, for those interested in real estate investment, platforms like Fundrise allow investors to access quality real estate deals previously available only to institutions, offering a way to diversify investments and improve returns on real estate investments.
