RateWatch #309 - Fixed or ARM?
June 22, 2002
By Dick Lepre

Fixed or ARM?

This is, when all is said and done, the classic risk vs. reward conundrum.

For the most part there are a lot of folks who have loan amounts over $400,000 who, for whatever reason, are looking at ARM's as alternatives. Let's look at a typical example. On Thursday a no point 30-year fixed rate loan of $400,000 was at a rate of 6.75%. A loan that was fixed for 5 years was 5.75%. The payment on the 30-year
fixed would be $2,594. The payment on the 5/1 would be $2,335. The difference is $259/month. If you had this loan for five years you would save 60 x $259 = $15,540.  For many folks this is well worth the risk associated with an ARM.  You could pay down your mortgage by that $15,540 and in the 60th month your loan balance would be that much less or you could invest that money or pay off other debt with it.

Then What

For folks into the "series of 5/1 ARM's" strategy you want, in all likelihood, not to do a no point loan but a "no cost" loan at a slightly higher rate and think about refinancing in 3-5 years.  This would give you a new 5 years of fixed rate.

But I'll Never Pay Off My Loan

Whenever you refinance you are getting a new loan with a 30-year term.  If you want to ever have your mortgage paid off you need to be vigilant about making the correct payment after refinancing.

This is best seen by example.  Suppose that you start out today with a $400,000 5/1 ARM at no cost and a rate of 6.0%.  Your payment would be $2,398/month.  Not let's suppose, for the sake of simplicity, that you could replace this in exactly 5 years with a new 5/1 ARM at 6.0%.  At the end of those 1st 5 years your balance would be $372,218.  You are getting a new 5/1 ARM with a 30-year amortization term. Your loan papers are going to say that your payment is 2,231/month. BUT... if you want to pay the new loan off in the same month that the original loan was to be paid off you need to pay the old $2,398/month and you will not be lengthening the duration of the debt.  In fact, you will be saving another $15,540 compared to the original, hypothetical 30-year fixed rate loan.

But There Has to Be Something Wrong With This

The 5/1 ARM is at a lower rate only because the lender is not assuming the rate risk for 30 years - just 5 years.  Thus you are getting the better rate.  What you need is a loan person whom you know can be counted on to prod you when it is time to refinance. 

The real question is this:  is it worth $15,400 (the extra interest with the  30-year mortgage) just to be sure that your rate will be 6.75% for the next 25 years.  That is rather expensive insurance and is the key to understanding why so may borrowers who want jumbo loans go the 5/1 route.

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