In our last post, we talked about the fixed-rate mortgage: what it is, and how it works. Today, we’ll talk about an alternative to the fixed-rate mortgage: the adjustable-rate mortgage. We’ll also work to figure out if the the adjustable-rate mortgage is right for you.
The Adjustable-Rate Mortgage
If you can dream up a financial product, chances are the bank has already beaten you to it. They’ve got whole teams of guys dreaming up new products . These brain centers of Wall Street have financial solutions for problems you don’t even have.
If it’s not already obvious, I’m skeptical of such offerings. You probably are too. (If not, maybe you should be.) Why is my guard up when it comes to bank products? Because lots of these offerings are good for the bank selling it, but bad for you. How can you tell if it’s bad for you? Here’s a red warning flag to help you figure out if you’re being sold something you don’t need: complexity. Usually, the more elaborate the financial product, the more inappropriate it is.
Are you ready for an example yet? Enter the adjustable rate mortgage.
Joe Danger, CPA works at Deloitte. He’s house hunting – and with a house in mind, he’s got to pick the right option to finance the purchase. (Naturally, Joe can’t afford to buy the house outright.) Joe is considering his options:
• 30-year fixed rate mortgage – with a monthly payment of $1,714
• 15-year fixed rate mortgage – with a monthly payment of $2,644
• 5/1 Adjustable rate mortgage – with a monthly payment of just $1,478 – for now
While the adjustable rate mortgage (ARM) is the cheapest, there are strings attached. What’s the string? The payment can go up. And in today’s interest-rate environment, it probably will. Let’s go back to Joe Danger, CPA, to see how he’s dealing with his mortgage payment.
Since Joe values cash-flow above all else, he opts for the adjustable rate mortgage. And it’s all working out pretty well for Joe – until he gets an interest rate adjustment five years down the line. He wasn’t prepared for the increased payment – and now can’t afford it. Even with salary increases over the last five years, Joe has amassed some additional debt in the way of wedding expenses, an engagement ring, and the honeymoon bill.
Unfortunately, Joe’s example comes from real life. I’ve had conversations with both friends and clients who are caught off guard by their variable mortgage. All were ill-prepared for the increased mortgage payments. Having a fixed incomes stream that was completely spent each month, they had no room for a larger mortgage payment in their budget.
Unfortunately, the ARM isn’t the only mortgage option that can subject to future increases. There are other complex finance instruments out there – those that tempt you in with an initial low payment, only to switch to higher payments later down the the line. These include the interest-only mortgage, and the balloon payment mortgage.
But, what if . . ?
Of course, there are always those who can really can plan for the larger payment down the line. Such disciplined people do exist. Or perhaps you have a plan to move in the next four years, making the 5/1 ARM make sense – as you’ll never be in the house long enough to ever have to pay the increased payments. Of course, the gods laugh when men makes plans. What if you decide to stay in the house for more than five years?
Answering the Question: Should I get a floating rate mortgage, like a 5/1 ARM?
If you’ve been reading this blog post, you already know that the answer is “No.” If you need the low rate offered by a floating rate mortgage to manage the monthly cost of a mortgage, then you probably have too much debt in the first place. The solution is not to pick the complex financial product, but to simply decrease your amount of debt. This may mean downsizing to a smaller home (and a smaller mortgage) or forgoing a mortgage entirely by selling your house – and renting for a short while. It also gives you opportunity to re-evaluate your budget. Perhaps you can manage your monthly mortgage by simply re-evaluating other things in your monthly budget – like an expensive automobile, or a permanent life insurance policy.
Lowering Your Monthly Mortgage Payment via Refinancing
One way to lower your monthly payment is to refinance at the same rate. This only works if you’ve already made a significant dent in remaining mortgage balance. (The consequence is the same when opting for a longer term mortgage from the get go: you’ll pay more in interest at each payment and over time.) But, it may be the only sensible option to get your monthly payment to fit within your budget. Moreover, doing so into a fixed rate mortgage won’t surprise with a higher payment later down the line.
Another way to get your interest payment down (and therefore your monthly payment down) is to refinance to a lower interest rate – if rates have dropped since you originally took out your mortgage. You can use the handy chart below to help you decide on the right course of action for lowering your monthly mortgage payment.