REALLY Low Interest Rate ARMS, Are They For You?

by Diane St James (c) 2004

If you have seen any of the ads about low interest rate ARM (adjustable rate mortgage) programs and laughed it off as some bait & switch type of loan or maybe even a typo, let me tell you they DO exist.

I recently joined forces as an originator with a mortgage lender that offers such a program and at first I thought there was no way I would ever tell anyone about it... that is until I truly learned the concept!

The main idea behind this mortgage is: by having a low minimum payment interest rate, you have the option of paying a lot less each month for your mortgage payment than you normally would for a standard 30 year fixed rate mortgage.

After doing a few calculations, turns out that the savings can be hundreds per month which translates to thousands per year!

This 'extra' money you save every month can be put to many uses! You can pay down credit card bills which you just haven't been able to chip away at until now, that undoubtedly keep racking up interest at a rate anywhere from 9% to 20% or more. You can start saving for your child's education, or even just invest this monthly savings in mutual funds or some other investment option of your choice.

I did some simple calculations based on a hypothetical loan of $150,000, at a rate of 1.25% and also at a rate of 5.5% for a 30 year amortization.

The payment at 1.25% was $499.88 and at 5.5% was $851.68.

The difference was $351.80/month or roughly $4200/year for you to use whatever way you wish (hopefully wisely).

If you were to invest this extra $4200/year into a fund earning monthly compounded interest at just 5%, you would have close to $24,000 by the end of 5 years and over $54,000 at the end of 10 years. Would you have been able to save that much on your own? I know I wouldn't because I haven't! Living paycheck to paycheck has become a way of life for many.

The only drawback I have found is that because there is a guaranteed low rate for a certain period of time, the true actual interest rate is going to be higher and therefore you are adding to the principal balance of you loan and not subtracting from it. This is called "negative amortization" when your payoff balance is higher than the original amount you borrow.

Now before you decide that this is horrible and there is no way you'd get into something like this, let me explain. Even though your balance is going up, keep in mind two things; first you have that extra money in your pocket (or hopefully invested earning some good interest); second there is a good chance that your home has been appreciating every year and therefore would more than offset the increase in balance if you were to sell it at a time when you owed more than you first did.

Most homes appreciate at least 3% each year and so by five years down the road, could well be worth 15% or more than when you first took on this mortgage.

In keeping with the example above, let's assume when you took a mortgage of $150,000 the value of your home was $167,000. After 5 years using a simple interest calculation it could easily be worth $192,050 (3% x 5 years = 15% x 167,000 = $25,050 + $167,000). While your payoff balance may be up to $165,000, your value has increased enough to more than offset the difference.

There are some things to look for when you are considering this type of loan:

1) Determine how long the option to pay at the low interest rate is in effect.

2) Determine whether there is a maximum negative amortization level which is actually a good safeguard.

3) Determine whether there is a lifetime cap on the interest rate.

If there is no cap, I wouldn't suggest that particular program. You don't want to have the potential of skyrocketing interest rates such as we did in the early 80's.

4) Find out what the margin is. This is the amount that can be added to the current index being used to determine that month's interest rate. Aim for a margin under 3.00%.

5) Determine if there are payment options each month based on what you are trying to achieve. The one I know about has different payment choices.

6) And as always, make sure the closing costs seem in line and watch out for junk fees.

There are other things that will be disclosed and should be reviewed, but I have listed the most important points.

Finally, this loan is NOT for everyone. If you are not disciplined when it comes to money at all, in other words you would just frivolously spend the additional savings you had without using some of this monthly savings toward a goal, you should stick to a regular fixed rate mortgage. Also if you live in an area where the property values haven't increased in years or are actually decreasing, I would not advise this program.

For the millions of the rest of you, this is a good program and one that might really help you realize some of your financial goals for the future.

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