I had an interesting conversation with a potential refinance client last week. He has a 30-year fixed-rate jumbo loan in the amount of $745,000 with an interest rate of 5.75 percent. He told me he is making significant extra payments on the principal in hopes of paying off the loan early and is interested in refinancing to a lower rate.
I told him that because of his loan balance, I couldn’t provide him with a lower 30-year fixed rate. I suggested that he consider a 7/1 adjustable-rate mortgage (ARM) with a rate that would be fixed for the first seven years at 4.25 percent. The rate can adjust annually thereafter.
I normally wouldn’t recommend an ARM to a homeowner planning to be in the property for a long time, but this ARM seemed to best match this gentleman’s objectives. Without getting into the numeric details, I created a spreadsheet comparing his current loan situation with a worst-case scenario if he refinanced to the 7/1 ARM. If he continued to make the same monthly payment, the concluding numbers were very interesting.
At the end of seven years, his principal balance under the 7/1 ARM would be lower by almost $80,000. This means he would gain $80,000 more equity making the same mortgage payments under the lower-rate ARM.
This particular ARM has annual and lifetime interest rate caps. Specifically, the rate cannot increase by more than 2 percent per year and can never rise above 10.25 percent. Using a worst-case scenario where the ARM adjusts to 6.25, 8.25 and 10.25 percent in years eight, nine and 10, and then remains at 10.25 percent, my borrower loses all of the $80,000 reaped in the first seven years by year 14.
This means that only after the first 14 years, my borrower is at risk of losing some money in the event interest rates rise to the double digits and remain there for more than 14 years. While most analysts are predicting rates to rise toward the end of this year, there’s no certainty that double-digit interest rates are on the horizon. In fact, interest rates are more likely to move up and down several times over the next 14 years.
I ran some more numbers without the worst-case ARM scenario. I assumed a 7 percent average annual interest rate under the ARM after the initial seven-year period of 4.25 percent. Comparing this scenario with my borrower’s current 5.75 percent fixed rate, his mortgage balance would be $67,000 less under the ARM by the end of the 14th year.
People’s perception of risk is interesting. To me, refinancing to an ARM under these circumstances poses very moderate risk with some guaranteed return over a 14-year period. Eliminating the unlikely worst-case scenario and replacing it with a conservative, but more likely, scenario, my borrower would come out well ahead under the ARM.
It’s interesting how some people find it acceptable to invest their hard-earned money speculating in risky stocks that easily could lose half their value. (Remember the dot-com bust?) But for some folks, borrowing cheap money with a guaranteed return over a seven-year period that could be lost only over the next seven years in a worst-case scenario is an unacceptable risk. Go figure.
Henry Savage is president of PMC Mortgage in Alexandria, Va. Reach him at henrysavage@pmcmortgage.com.
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