ARM or Fixed Rate?

Asked by HomeBuyer, Jersey City, NJ Fri Sep 21, 2012

Hi, the rates are low and I am getting a very low ARM compared to the 30Yr - it pays 30K less in 5 years than a 30Yr. I understand rates may go up later, but is it not possible to refinance any time to Fixed once a rate uptrend sets in?

My LO has a bias towards Fixed and wont give me that answer clearly. Please let me know your understanding and experiences on this. Thanks.

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, ,
Fri Sep 21, 2012
I've never heard of a loan that you could not make prepayments on. There are some loans that will impose a penalty if you prepay over a certain amount within a certain time period (such as paying 20% or more of a balance within a 1 year period) which is called a prepay penalty. But prepay penalties aren't very common on mortgages anymore. So unless the fixed rate mortgage specifically has a prepay penalty then you can still prepay on that loan without any penalties. Ask your loan officer if it has a prepay penalty or not, and if it does, how long the prepay penalty would be for (rarely over 3 or 5 years) and if it's a "soft" or "hard" prepay penalty. A soft prepay penalty would allow you to sell your home without penalty, but would impose the penalty if you were to refinance or pay your principal balance down by a certain amount... a hard prepay penalty would be imposed even if you sell.

Also if you make a large principal prepayment, most lenders will allow you to "recast" the loan to make your payment based on the new principal balance based on the remaining term of the loan. Like if you start out with a $800k loan amount over 30 years, and pay $150k towards it in year number 2, then your payment would be recast to be on a $650k loan amount over 28 years. Not all lenders permit that but most of them will as long as you discuss it ahead of time.

Rates can increase pretty quickly, they usually increase at a much more rapid rate than they decrease. I remember back in the summer of 2004 they increased over 1% in a little less than 2 weeks time period. Rates can also go up & down, just like the stock market, so there may be a period of a couple months where they rise but then the following couple months they could decrease down to where they were prior to them rising. There is also the factor of denial. Denying that rates will continue to increase, just like a lot of people were in denial that home values were going to significantly decline and thought they'd make a comeback to where they previously were.

Shane Milne | Lending in all 50 states | NMLS #81195
1 vote
HomeBuyer, Home Buyer, Jersey City, NJ
Fri Sep 21, 2012
Thanks everyone. The reason I am considering ARM is two fold - lower monthly, and abilit to PrePay. I have a jumbo loan and I'd like to bring the monthly down by prepayment. Fixed doesnt allow that, as I understand.

Does that make sense to get in an ARM for the initial period and switch to a Fixed later when the balance is down to lower monthly payments?

About the possibility of higher rates then, isnt it right that rates would get there in some sort of a incline and will offer time to enter at the uptick, rather than just hitting the roof? I mean, if one can be sure of the cash and credit situation, one should be able to refi AS the rates are climbing.

0 votes
, ,
Fri Sep 21, 2012
Refinancing requires you to re-qualify for the mortgage all over again. If home values are going up, you maintain your credit rating, your employment is steady, and your income & debt levels don't get worse then it is usually relatively easy to refinance. However what a lot of us loan officers are seeing today is that home values aren't as high as when the homeowner purchased their home, giving them less equity (especially if they haven't paid down the principal balance by the amount their value has decreased) and then that may create a requirement to bring in funds at closing in order to complete the refinance - something that the majority of homeowners aren't too hot on doing.

For example if someone purchased their home for $300k with a 20% down payment (avoiding mortgage insurance) and then their home value fell to $280k when they attempted to refinance, then to continue avoiding mortgage insurance the new loan's principal balance couldn't be any higher than $224k. If the mortgage balance is still close to $260k (what it'd be on a $300k sales price after 20% down), then that would require ~$36k to be brought in at closing (in addition to the new loan's closing costs, unless the lender is offering a special deal where they'd pay closing costs). If that person was fine accepting mortgage insurance, then they could potentially refinance at 95% of their home's $260k value (or 97% with FHA financing), which would be a loan amount of $247k ($252,200 with FHA), and less funds would need to be brought in at closing.

So if you will be able to bring in funds at closing, then you likely could be OK refinancing later if home values decline (barring any other changes to underwriting criteria between when you purchase & would eventually refinance).

Shane Milne | Lending in all 50 states | NMLS #81195
0 votes
, ,
Fri Sep 21, 2012
Hi HomeBuyer,

It depends. Can you be disciplined and pay extra towards your principle balance and/or stash away that difference in payments in a savings account?

This exact line of thinking got a lot of people into trouble. Sure, theoretically you can refinance to a fixed rate at any time, as long as you have enough equity in your home and you still qualify under the program underwriting guidelines. These are the reasons so many people ended up in foreclosure. The time comes for them to refi to a fixed rate but they didn't have enough equity or they didn't qualify under the ever changing underwriting requirements.

You also want to take into account the future cost to refinance and what happens if there is a sudden spike in rates and you end up with a fixed rate of 6%.

If you're disciplined and you make the right moves with the money saved, it could make sense for you but you need to be aware of the risks.
0 votes
Suzanne MacD…, Agent, Succasunna, NJ
Fri Sep 21, 2012
Fixed rate. What goes up must come down and what goes down will go up. Once the uptrend starts it will be too late. Interest rates have never been so low. They won't stay this low forever and they just can't go much lower or the banks will actually be losing money once they pay for the servicing of the loan.
0 votes
Karina Abad, Agent, Basking Ridge, NJ
Fri Sep 21, 2012
Hi Hombuyer, I am also biased towards fixed rate. It's a much more conservative loan and minimizes risks and possible upswings in payments in the future. Yes you can refinance in a month if you decided (unless there is an early prepayment penalty) but you will need to have a certain percentage of equity before you can do so, and keep in mind you will need to pay closing costs again so it may not be worth it. I would go with the a 30 year rates for 30 year are insanely low also.

0 votes
Amos Elroy, Agent, Bayonne, NJ
Fri Sep 21, 2012
Not a mortgage guy, but this is something that landed so many people in trouble.

Personal thought, bad idea!


Amos Elroy
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