an ARM Wrestling exercise

Not a week goes by where I don’t hear someone in the PF community deride hybrid-ARM mortgages. It’s always the same story – a poor homeowner can’t make their mortgage payments when their ARM starts adjusting up, up, and away. The message is always implicit – adjustable rate mortgages are for dummies and smart people always go for the fixed rate.

No. No. No.

The average mortgage in this country lasts for about seven years. People change jobs. People upgrade. People move. So in a perfectly rational world, the “average” home loan should be a 7 year fixed, adjustable rate mortgage. But guess what? The most popular home loan is a 30-year fixed.

On the average, people demand more security than they really need. If a 30-year fixed loan is the most popular, it is—by definition—demanded the most heavily. Let’s trot out our freshman year economics textbooks and look at that graph of price and demand.

Assuming a healthy credit score, the ARM’s that are available to you are almost entirely defanged. They have caps on the amount they can move per year; the rate has an absolute ceiling; they don’t negatively amortize; they don’t have early repayment penalties. In return for taking on the risk of a fluctuating rate, you’re rewarded with a lower intro rate. So if you’re an average homeowner who takes out a 10/30 ARM, you’ll never see the rate bounce! Naturally, the same argument goes when the loan is paid off before it adjusts.

This is exactly what I was thinking when I took out my 5/30 ARM. When I bought, there was simply no way that a fixed rate loan could compete with a 4.875% ARM. Considering that I’m well on track with my 24-month mortgage plan, selecting a fixed rate loan would have been tantamount to flushing money down the drain.

While I don’t doubt there’s the occasional boob out there that gets “adjusted” out onto the street, the ARM was more of a symptom of a more reprehensible problem--predatory lending. I genuinely believe that the vast majority of us who opt for an ARM do so with our eyes wide open. We know what we’re getting into. And we do it because it’s simply the smart choice to make.

Let me drive home the point. My ARM will begin to adjust in 2010. Let’s assume that I make minimum payments to my lender up until that point. Now let’s assume that my ability to pay my mortgage experiences no growth over the next four years. So in the most (unrealistically) conservative case, how much “rate adjusting” can I absorb before I can’t make my mortgage payment anymore?

Take a guess before you continue reading. I’ll post the answer at the bottom of this page.

When it comes to selecting a mortgage, give some serious thought to how long you plan on paying into your loan. Your ability to plan ahead could end up saving you thousands in interest.

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* My rate could adjust up to a 110.7% APR. Yes Virginia -- that’s beyond absurd.