by Pat Zaby
May 24, 2010 12:44 PM
With the incredibly low rates that fixed mortgages are priced currently, very few buyers have even considered adjustable rate mortgages. Agents haven't been recommending them because the buyers are readily accepting the rate on the fixed and there really hasn't been the need to suggest something different.
In some situations, the adjustable rate really is a better alternative because it will allow the buyer to have the lowest cost of housing due to the lower interest rate. The buyer needs to be relatively certain that they won't own the home long term and have a reasonable expectation as to when they will sell it. Typically, a borrower who selects an ARM is not adverse to risks and may have a better than average understanding of financing.
Most people think that the breakeven point comparing an adjustable rate to a fixed rate occurs when the rate on the adjustable exceeds that of the fixed rate. Actually, the breakeven occurs when the cumulative savings from the lower payments is exhausted. When the buyer is confident that they'll be selling the home prior to this breakeven point, the ARM will have a lower cost of housing and may be the better choice.
A conservative way to calculate the breakeven point is to assume that the rate would adjust upwards the maximum possible amount at each adjustment period. This would determine a point in time when the savings would be exhausted. If the loan were not to go up the maximum amount at each adjustment period, the point in time would be extended.
FHA adjustable rate mortages have lower periodic and lifetime adjustment caps than conventional ARMS. Instead of a maximum adjustment of 2% each period and 6% for the lifetime for most conventionals, FHA has a 1% maximum per period and 5% over the lifetime.
In the example shown, the buyer would save $198.88 a month on the ARM for the first five years which would total $11,932.80. If it adjusted upward the maximum in the first period, it would then be at 4.375% which is still less than the fixed rate and the buyer would save another $53.94 for the next 12 months. At the end of six years, the accumulated savings would be $12,580.08.
It would be easy to determine that if the buyers knew they were going to stay in the home for less than six years, the adjustable rate mortgage would be the best choice for delivering the lowest cost of housing.
The price of the home is only one element to the cost of housing. Selecting the appropriate mortgage is easily as important and deserves careful consideration.