Ready For Retirement

Are Adjustable Rate Mortgages Right for You in a High Interest Rate Environment?

August 29, 2023 James Conole, CFP®
Ready For Retirement
Are Adjustable Rate Mortgages Right for You in a High Interest Rate Environment?
Show Notes Transcript Chapter Markers

Are short-term savings using an adjustable rate mortgage worth the risk of rate hikes? In this podcast, we cover how adjustable rate mortgages (ARMs) work, how they differ from fixed-rate mortgages, and the reality of their adjustment periods. 

James uses a real-life scenario to dive into the comparison of adjustable and fixed-rate mortgages. Learn how to plan for the worst-case scenarios and evaluate the benefits and drawbacks of each option. 

Questions answered:
Is it better to get a fixed rate mortgage, or is it better to get an adjustable rate mortgage? 
What is the risk versus reward?

0:00 Intro
3:10 Buying a home
5:18 How ARMs work
7:24 Why use an ARM?
10:11 What's the risk?
14:07 When not to get an ARM
16:15 When to get an ARM
18:50 Other considerations
20:21 Analysis
21:06 Outro

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Speaker 1:

High interest rates have driven the cost of mortgages up by 40-50% or more over the last couple of years. This, combined with a relatively stable housing market, has made buying a home significantly more challenging. So this challenge now has many people wondering if they should use an adjustable rate mortgage to keep their monthly payments down. But is that really a good idea? In today's episode, we'll discuss the pros and cons of adjustable rate mortgages and help you decide if one is right for you. This is another episode of Ready for Retirement. I'm your host, james Cannell, and I'm here to teach you how to get the most out of life with your money. And now on to the episode. Today's episode is based upon a listener question, and what you'll notice as I read off this question is some of the interest rates I'm referencing are very clearly not the interest rates we have today. However, the principle behind this listener's question is still very much the same, and that comes down to what is better in today's interest rate environment. Is it better to get a fixed rate mortgage or is it better to get an adjustable rate mortgage? I'll dive in more to that in just a second, but before I do so, want to read the question. This question comes from John, and John says my wife and I are looking to purchase a new home. The mortgage broker is recommending a seven or 10-year arm. Arm, by the way, stands for adjustable rate mortgage. The interest rate on the seven-year arm is 4.25% and the interest rate on the 10-year arm is 4.5%, while a 30-year fixed mortgage is 5.25%. Does the savings of one of the adjustable rate mortgages justify taking the risk associated having to refinance at a future unknown rate? Does the answer change as interest rates increase further? I would hope we would still be in our house at the end of those arms adjustable rate mortgages. And that is from John. Well, john, thank you for that question and, yes, the interest rates that he's referencing. This is very clearly a question that was submitted several months ago, so those interest rates are no longer the current rates that we're hearing today. But the reality is, by the time you're actually listening to this, interest rates will probably be a little bit different, and in six months or 12 months or 18 months, interest rates will be a little bit different. So, instead of just looking at those specific rates, what we're going to do today is walk through a framework of how should you think about this and how does that framework stay consistent even as the actual interest rates will change going forward? Now, before we jump in, I always like to highlight the review of the week. Thank you, by the way, to all of you who have taken the time to leave reviews. This review comes from username Slilonic, and Slilonic leaves a five star review and says I really appreciate this podcast for bringing up so many different client scenarios in the many ways to think about possible solutions. I'm an aspiring financial advisor and I'm very early on in my career. This podcast is a great addition to my daily routine to help educate me on financial planning. I'm currently enrolled to get my bachelor's degree in CFP certification and listening to this podcast has really helped me to solidify everything I'm learning. Thank you, james, for all the things you talk about and the excellent way you go about explaining it all. And that is the end of the review. Well, slilonic, thank you very much for that review. I appreciate it. Best of luck with all the studying. It's a wonderful career, so I'm glad this podcast has been helpful as you've been studying to enter it. So let's now jump right into the content. When you go to buy a home and this could be the first time you buy a home. It could be because you're buying a rental property. It could be because you're selling your current home and relocating somewhere else. All that is going to be the same in terms of what we're talking about today. When you go to acquire that new property, how do you finance it? Yes, if you have all cash this conversation is a little bit irrelevant but if you're going to take out some type of a mortgage, you need to understand what those mortgage options are and you need to understand which one might be best suited for different types of situations. So when you look at mortgages, traditionally, the most common option is a 30-year fixed mortgage. You borrow some, some of the money from the bank. The bank says here's the interest that we're going to charge you for the life of the loan and you have one single fixed payment for all 30 years, until your mortgage is fully paid off. You could have the same thing for 15-year mortgages or even 20-year mortgages, where you get a rate and what the bank does is they amortize your payment, saying, based upon this interest rate and this amount that we're letting you borrow, here's your payment that you're going to pay us for the end of the term or until the end of the term, whether it's 15, 20, 30 years. So those are standard mortgage options. Those are the most common. But there also are alternative mortgage options. You could have interest only mortgages, where you borrow some of money and you just pay interest on that mortgage until some balloon payment is due or until you've fully paid it down. You could also have adjustable rate mortgages. In adjustable rate mortgages this is what John is referring to in his question, and the way an adjustable rate mortgage works is they might say James, you can borrow money from us and we're going to give you one interest rate for maybe five years or seven years or 10 years. And if you hear someone say I'm getting a five-one arm or a 10-one arm, what that's saying is that first number is how long is the initial interest rate good for, and then one is the frequency so every year, that that interest rate can be readjusted, and we'll talk about the method by which it does that in just a bit here. But when you get an adjustable rate mortgage, what you're doing it for, the reason you're doing it is you're getting a lower interest rate than if you were to go get a 30-year mortgage for that same amount. So let's real quickly work through how adjustable rate mortgages work, because understanding this although many of you might already know, but understanding this is kind of fundamental to knowing. Should I go with this option versus should I go with a more traditional 30-year fixed type mortgage option? So here's the quick rundown on how adjustable rate mortgages work. You'll typically see something like five-one arm or seven-one arm and, as I mentioned before, that first number is how long the mortgage is fixed for. So if we use a five-one arm and again arm stands for adjustable rate mortgage, that means that for the first five years alone you're going to have a fixed interest rate. The second year, so in the five-one, the one indicates how many times per year the interest rate can be adjusted after that initial time of the interest rate being fixed. So after the first five years in this example, then the interest rate could go up or could go down, but it goes up or down based upon some index rate such as the London Inner Bank Offer rate, so LIBOR, for example. So what you're going to have is the mortgage company will say we're going to adjust your rate at LIBOR plus 3%, for example. So if LIBOR, so if the London Inner Bank Offer rate which is a rate that you're never going to be able to borrow money at, but it's kind of like the rate at which all other rates or many other rates are based on if LIBOR is at 3% and if the margin on your loan is at 3%, then your rate is going to be 6% after the initial five-year term is up. If LIBOR goes up to 4%, then your rate is 7%. So it's still that 4% LIBOR plus 3% margin. That's the adjustable part of the name. So the amount of the adjustable rate mortgage can then adjust each year after the initial fixed time period, and then there's typically some cap on what's the highest this rate could go to over the life of the loan. So, for example, maybe the cap is 8% or 9% or 10% or whatever. It is essentially telling you if you get this mortgage, your rate will never go above 10%, even if LIBOR were to go much higher in an extreme example. So, with that basic understanding, why would anyone select an adjustable rate mortgage If you're now at risk of having your mortgage payment go way up, if interest rates go way up, why on earth would anyone elect this? Hey, everyone, it's me again for the Disclaimer. Please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner. Nothing in this podcast should be construed as investment, tax, legal or other financial advice. It is for informational purposes only. Well, you would choose an adjustable rate mortgage because for that first five years, or seven years or 10 years, whatever that first number is in the five, one or seven, one or 10 one title of the loan the interest rate is going to be lower than it otherwise would have been if you had elected a third year mortgage. So let's take an example of where rates might be today. Now, granted, all of these rates are going to depend, in terms of you getting an actual mortgage, on your credit score, the loan amount, other factors, where our current interest rates. But just for the sake of example, let's assume that you could go out and you're trying to borrow $500,000 to buy a home. Well, you could go get a 30 year fixed mortgage and let's assume the interest rate on that is 6.75%. Or you could go get an adjustable rate mortgage and the interest rate on that is 5.5%. Well, you can see right off the bat why someone might at least be intrigued by this adjustable rate mortgage option, that interest rate is lower than the 30 year fixed rate. Now let's compare the payments again, assuming a $500,000 mortgage, if we're just looking at the principal and interest portion of the mortgage, so excluding property taxes or insurance, so excluding any of the escrow part a 30 year fixed mortgage at 6.75% on a $500,000 loan, your monthly principal and interest payment would be $3,243 per month. If you were to get that same $500,000 mortgage but you used a 5.1 arm at 5.5%, well now your payment would be $2,839 per month. So as you look at these numbers, the principal interest payment for the 30 year fixed mortgage is 14% higher than the arm was and the adjustable rate mortgage was. So that's a pretty dramatic difference. As you're doing your home shopping and you're trying to think, where do we want to buy next? Where's our family going to live A 14% difference and a fairly large expense that adds up. So you look at that adjustable rate mortgage and that's very appealing to say can I get a mortgage rate that saves me a few hundred dollars each month? And now here's the thing. If we knew the interest rates were only going to get lower between the time we take out that loan and the time that loan is paid off. The adjustable rate mortgage is the way to go. You're going to start out with a lower rate, and that lower rate is going to continue even after the initial fixed rate is up. After that 5, 7, 10 years, whatever it might be. What is the risk, though? So why wouldn't you move forward with that? Well, the risk very clearly put is that interest rates go up. So let's take a look at that as an example. Assume you get a 5, 1 arm on a $500,000 loan at the rates we just looked at. So you get a 5.5% interest rate, when you otherwise would have had a 6.75% fixed rate if you got a 30 year loan. Well, let's assume that after five years is up, interest rates have gone up and your new rate is 7.25%. What happens is your mortgage company takes your remaining balance, and you would have paid some of your mortgage down by that point. But they take your remaining balance and they re-amorotize it every single year, assuming that an adjustment was made to the interest rate. So, based upon, in this example, still having 25 years left to pay this off, the mortgage company would say what's the new loan amount? Well, if it started at $500,000, assuming you made the minimum payment of $2,839 per month for the first five years, your actual balance would be down to $462,300 at the end of those five years. They would then take that new balance, re-amortize it at 7.25% and now your payment would go up to $3,342 per month. Now that's an 18% increase, so that if you're looking at it, you may not be able to afford that. That's the risk. If your mortgage payment all of a sudden was almost 20% higher, would that still fit in the budget or would you be forced to move or at least cut some expenses pretty dramatically? Now some of you might be saying well, james, sure that's an 18% increase, but that new payment is only $100 more per month than the 30-year fixed mortgage. Otherwise it would have been Because, again, the new payment on the adjustable rate mortgage, after it re-amortizes assuming a 7.25% rate your new payment is $3,342. The initial 30-year fixed mortgage was at $3,243 per month. So you can look at that and say, oh my gosh, in that case and now I'm just making up these numbers that case it could be worse, that rate could be higher. But in that case you might look at that and say worst case scenario, or maybe common case scenario is my payments $100 per month higher than what it would have been with a 30-year fixed from the beginning. You might look at that and say that's not so bad, or you might look at that and say, well, I couldn't afford the 30-year fixed rate to begin with, let alone anything higher than that rate. So this is very much where you have to understand your own cash flow and your own personal situation and your own contingency plans when you have a mortgage rate that's not fixed and that could go higher, which would lead to higher payment amounts. So, put very simply, when you're asking should I use a 30-year fixed mortgage or should I use an adjustable rate mortgage, you just have to be aware of the risk and that's the risk. The risk is interest rates can go up and if interest rates go up, your payments go up. So if you're getting and if you're reaching for that adjustable rate mortgage because you say, oh, I just can't really afford that 30-year fixed rate, but I could afford the adjustable rate mortgage and I'm just hoping the interest rates will be lower in five years or seven years when that initial term is up, that may be wishful thinking. Remember, if we just look back at 2022, many economists at the beginning of that year assume that rates would probably go up by about half a percent in 2022. Instead, they increase by over 4%, one of the most actually the most dramatic increases in the federal fund rates that we've had in the history of the Federal Reserve, in terms of how fast rates rose. Now will they keep going up, will they go down? How long will they stay high? How long would they maybe stay low? It's just a guessing game. No one really knows with certainty. So if you're going to go with that adjustable rate mortgage, it's not necessarily the worst thing in the world to do so, but make sure you're well aware of the possibility that your rate might be higher in five or seven or 10 years than lower. So don't go into this and get an adjustable rate mortgage if the only way you could possibly afford it is if interest rates happen to be lower in five or seven years than they are today. If that's the case, not only are you setting yourself up for potential disaster, but, more importantly, you're going to have a huge amount of anxiety in a year, two years, three years, four years, as you know that your ability to maintain your home, your ability to house your family is contingent upon something that's completely out of your control. Now, this is where there's other factors that you have to look at. So here's those other factors. Let's assume that you're considering mortgage options and there's a pretty significant spread between an adjustable rate mortgage and, say, a 30 year fixed mortgage, and by spread I mean the interest rate difference is pretty significant. Well, if you're considering and I'm just going to use a 7-1 arm in this example if you're considering a 7-1 arm versus a 30 year mortgage and you know with certainty you're not going to be living in that home after seven years, an adjustable rate mortgage probably makes a lot more sense. You're essentially locking in that interest rate and you know that you're not going to be in the home after that initial interest rate stops being fixed and begins to adjust based upon current interest rates. So if that's the case, an adjustable rate mortgage might make a lot of sense. Now I would give you another piece of advice there, that if you know for certain you're not going to be in a home longer than five or seven years, does it really make sense to buy that home to begin with. If the home is going to appreciate quite a bit then? Yes, but there's a lot of studies and if you actually run some of the numbers, there's a lot of costs and your first few years of home ownership. It's everything from closing costs to the fact that when you get a mortgage whether it's an adjustable rate mortgage or fixed the first several years of payments are primarily interest payments, which means you're really not building equity with most of your payment. There's property taxes. There's a broker commission you're going to pay when you sell the property. There's maybe new maintenance costs when you first move into a place, when you start to look at it. The first few years the chances of you actually making money if you know for certain you're going to have to sell within, say, five years aren't actually that high. What you'd have to be depending upon to make money to buy a property and quickly sell it is for the appreciation of property to increase rapidly. So are you either doing something internally and renovating the home to make it more attractive, more valuable, or do you get to participate in market forces driving the price of that home higher? If that's not the case, then you may not be wanting to buy that home. If it's just for a short-term hold anyways. So that's for a separate episode. But point number one is if you know for certain you won't be in a home for a long time and if you know for certain you are actually going to buy it. That's when an adjustable rate mortgage might make more sense. The second case where an adjustable rate mortgage might make more sense is you know you'll have the means when the adjustable rate actually starts happening. So after the fixed rate is up and the rate starts to adjust after the five-year, seven-year term, you may be in a different financial situation. I'll give you a perfect example of this. There was actually a couple of different clients I was talking to recently, both acquiring new homes because they're moving to different parts of the country, and we had the conversation of how do we finance this? There's going to be a good portion as a down payment, but for the remainder, is it adjustable rate mortgage? Is it interest only? Is it a fixed conventional mortgage? And as we started to run the numbers, we weren't just looking at well where interest rate's going to be, what's the payment going to be, all those things. Those are absolutely important. But we were looking at our big picture financial plan and one of them in these instances had pretty significant deferred compensation payments being paid out over the next five to seven years. Now why does that matter? Well, in his situation we determined it probably makes most sense to get an adjustable rate mortgage to lock in a lower interest rate because, worst case scenario, if interest rates do skyrocket, what you've got some pretty significant deferred comp payments come in in. Those payments can simply be used to pay off the mortgage at that point. So that's an example of where I would say understand what your financial situation will look like at that time. If you have the income to support a higher payment once interest rate adjusts, or if you have liquidity or assets to pay off the mortgage, if you determine that's best if the interest rate adjusts, then you're in a much safer position than if you buy a home and you really don't have the means to pay a higher mortgage. You don't have liquid reserves to pay down the mortgage balance if needed. And now you're in a tough spot where, if interest rates go up and you have an adjustable rate mortgage, you're forced to make some very difficult decisions, one of which might be selling the home and moving somewhere else that you could afford. So make sure you know your situation. Another example of where your situation really ties into this is maybe you have some pretty significant expenses, maybe you're paying for children's college, maybe you have a vacation home or rental property that the mortgage is going to be paid off soon, say within the next five years. Well, if that's the case and you've got some pretty significant expenses falling off, after five years you could afford for a little bit of an increase or maybe even a quite substantial increase worst case scenario to your mortgage payment after five years, once that interest rate adjusts on your adjustable rate mortgage. So it's all about understanding, not only comparing the options between adjustable rate mortgages and your fixed rate mortgage options, but also understanding your specific situation when that adjustment time comes. Would you be in a position to potentially have to pay a mortgage that's 10%, 20%, 30% higher? If the answer is yes, well, there's less risk in getting that adjustable rate mortgage. If the answer is no, now all of a sudden, there's a lot of risk in getting that adjustable rate mortgage. So finally, when you look at all this, if you knew a certainty that interest rates are going to drop and that you could refinance once that adjustment period happens, there's really no reason to not get the adjustable rate mortgage, but again, we don't know what interest rates are going to do. Is it likely the interest rates will drop at some point? A lot of people certainly say so, but again, keep in mind that nobody was forecasting rates to go up like they did in 2022, where the Federal Reserve increased rates the fastest it ever had before. So when you look at this, it seems like a fairly simple analysis, and to an extent it is. When you're just comparing mortgage rate options, you can run the numbers on a fixed mortgage, you can run the numbers on an adjustable rate mortgage to see what that payment looks like, and then you could run it to see what might the payments be on an adjustable rate mortgage, based upon what I like to call worst case scenario. What's the most? They could go up after five years or 10 years or 15 years, based upon the terms of the loan, and then look at your personal financial situation. If that worst case scenario were to happen even if it's unlikely, you could run the numbers like that Would you be in a position to be able to roll with it, or would you be in a pretty tight financial situation where it would cause you a great amount of financial distress and even lead to a potentially very negative outcome. So that is it for today, john. I appreciate that question. For all of you who have left reviews, I appreciate you doing so. If you have not already done so, please take a moment. Click five stars if this show has been valuable to you at all, and also an announcement. It's been this way for a couple of weeks now, but we are on YouTube. The YouTube channel used to be under root financial. Just now, just under my name, james Cannell, c-o-n-o-l-e. So check out this podcast. Also check out other great videos on our YouTube channel and again, that channel name is James Cannell. So that's it for today. Thank you, as always, for listening and I'll see you next time. Thank you for listening to another episode of the Ready for Retirement podcast. If you want to see how root financial can help you implement the techniques I discussed in this podcast, then go to rootfinancialpartnerscom and click start here, where you can schedule a call to one of our advisors. We work with clients all over the country and we love the opportunity to speak with you about your goals and how we might be able to help. And please remember, nothing we discuss in this podcast is intended to serve as advice. You should always consult a financial, legal or tax professional who's familiar with your unique circumstances before making any financial decisions.

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