ARM’s Can Build Equity Faster than Conventional Loans

Adjustable Rate Mortgages (ARMs) are usually chosen by people who know they will be moving in a few years, and by those who are willing to gamble on what mortgage rates will be when the ARM adjusts. What few people think about, however, is that an ARM also lets you build equity in your home more quickly than you would with most fixed-rate loans. Before looking at how an ARM can help you build equity quickly, let’s look at how it operates. With an ARM, the interest rate will change after a set period. That’s why it is called adjustable. With a fixed-rate 30-year mortgage the rate will remain constant for the life of the loan, no matter what interest rates do. With a one-year ARM, the rate will adjust after one year. With a three-year ARM, the rate adjusts after three years and is subject to change every year thereafter. There are also five-year, seven-year and 10-year ARMs. Even though this column will not focus on what to look for and what to avoid in an ARM, there are a few points to remember. An Adjustable Rate Mortgage is actually a 30-year mortgage in which the interest rate can and usually does change over time—often several times. It’s important to know what sort of restrictions there are on those changes. Is there an annual cap that limits how much the rate can increase in any one year? There should be, and it should be no more than 2 percent. Is there a ceiling that limits the total increase that the ARM can reach over the life of the loan? There should be a limit on that, too. Many lenders offer a 5 percent or 6 percent ceiling. Ask potential lenders about these limits.

Use an Adjustable Rate to Build Equity

The focus here is how to use an Adjustable Rate Mortgage to build equity. Although it does so automatically, we will also look at how to use an ARM to build equity even faster. With a good credit history and enough income to make payments, you could likely qualify for a 30-year conventional loan at 5.375 percent. If you took out a $100,000 loan, your monthly payment would be $559.97. This does not include any taxes, insurance or other fees or assessments. The $559.97 would be your payment for 30 years, no matter where interest rates go. If you qualify for a 5.375 percent 30-year loan, you could also probably qualify for any number of ARMs, as well. For a one-year ARM your current interest rate would be 3.375 percent or 3.625 percent for a three-year ARM. A five-year ARM would go for 4.375 percent and a seven-year would be 4.75 percent. As you can see, the shorter the term of the Adjustable Rate Mortgage, the lower the rate. But once the introductory term of your ARM ends, the rate could climb. The lender doesn’t know what the interest rate will be in five, 10 or 30 years, so he or she is looking for the best interest rate possible. Since it’s more difficult to predict where rates will be in 30 years, the interest rate on a 30 fixed-rate mortgage will be higher than the rate on an adjustable. We’re going to look at the three-year ARM for the sake of comparison. At 3.625, the basic monthly payment would be $456.05, or almost $104 a month less than the 5.375 percent loan. That payment would only be in place for three years. After that, while it is conceivable that it could go down or stay the same, it might also go up.

How You Build more Equity with ARM’s

If you had the 5.375 percent 30-year loan and made your payments every month, at the end of the first three years you would have paid $20,158.96, not counting taxes, insurance and so on. Of that, $15,792.13 would have been paid toward interest and you would still owe $95,633.17 toward the principal on your house. With the three-year ARM at 3.625 percent, at the end of the first three years you would have paid $16,417.84. Of that, $10,571.69 would have been in interest, and you would owe $94,153.85—compared to $95,633.17. The ARM would allow you reduce your principal—and build your equity—by an additional $1,479.32 even though you paid $3,741.12 less in total monthly payments. It would take you an extra 11 months to get your principal down to that amount at 5.375 percent interest.

The Downside of ARM’s

The downside of this, of course, is that you don’t know what the new interest rate will be at the end of the ARM. If, however, you know you’ll be moving at that time, what difference does it make? If you have to buy a new house, you’ll have a new mortgage and a new interest rate anyway. If all you do is make the payments that are called for in the three-year loan in our example, you will still end up saving nearly $4,000 in monthly payments while increasing your equity by almost $1,500. But now let’s look at what would happen if you had taken the 3.375 percent loan and made payments as if it were a 5.375 percent loan. If you had the three-year ARM and added that extra $94 a month to your loan payment, at the end of three years you would have paid an additional $3,384, which would have been applied to your principal. As a result, after three years your principal would be $90,586.62, which means you reduced your loan balance by slightly less than 10 percent. But you would actually have reduced it even more. Since the mortgage interest you pay every month is based on the amount still owed, every time you make an extra payment you are reducing the amount you will have to pay interest on for the next month. This means that more of your payment will go toward the principal–reducing it even further.

So should you get an Adjustable Rate Mortgage or a conventional mortgage? As with any financial decision, study all your options and then decide what works for your particular situation. You may find an ARM is the best way to build equity, which brings you that much closer to the goal everyone dreams of—not having a mortgage payment at all.

Reprinted in its entirety. James R. De Both is a nationally syndicated financial columnist and is the President of Interest.com ©1995-2004 Interest.com All rights reserved. Copyright Interest.com, 630-834-7555