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Help! My Adjustable Rate Mortgage (ARM) kills me!

 

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Question:

I purchased a home for $720,000 in San Jose, California near the housing peak in July 2005. I got a 3-months fixed term (3 months ARM), after 3 months the rate floats. The ARM loan balance is 95% = $684k, it is an interest-only loan. The remaining $26k are financed through a HELOC on another house in San Jose. Now Alan Greenspan has raised the rates so often, my HELOC payments have gone up. My 3-months ARM has converted now from 4% to something higher. What shall I do?
I want to stay in this house permanently, not only for a few more years.

Answer:

The ARM most likely has rate of 6% now. ARMs typically can adjust by 2% annually only, and they will do that every 12 months. So in July you got 4% interest. Review (adjustment) was scheduled for October. The rate for October 2005 would be 6%.
In October 2006 your rate will be reviewed again, most likely it will be 8% then.
October 2007 it may be 10%.
It will increase until it has reached what your loan papers describe. The paper will typically say that the loan is adjusted to LIBOR + x% e.g. LIBOR + 2.25%.

LIBOR means 'London Interbank Rate' and currently LIBOR is 7%. This rate is identical to what is referred to as 'PRIME'. Historically, PRIME has been as high as over 20% - look at the table of historic PRIME rates, in May 1981:
Historic PRIME Rates

If we assume that PRIME will rise to 7.5% - which is very realistic - then your loan would adjust to 7.5% + 2.25% = 9.75%

Note that your loan may actually have a different value for the 2.25% - you need to read your papers!

Your schedule would be:
4% July 2005
6% Oct 2005
8% Oct 2006
9.75% Oct 2007

Your original interest portion on the 680k loan at 4% was $2267 a month.

At 6% it is now $3400 a month! I sure can feel your pain!

In a year from now it will be $4533.

The final rate in October 2007 will be $5525.

$5525 a month in interest only, as opposed to $2267! Will your monthly income have gone up by $3200 during the next 2 years as well?

Not to mention, what happens if PRIME rises beyond 7.5%? What about 8% - another $300 per month for you.

You see, it really makes sense to get rid of the adjustable rate now.

When talking to the loan broker, you will be offered choices like

- 5.1% for some sort of ARM.
Really, they can offer you all kinds of numbers, the details are in how it will adjust once the fixed term is over. PRIME + how-much?

- 6% (something like 6%) for a 30yr fixed.

You probably cannot afford a 15year amortization on a 680k loan. Therefore you should try as hard as possible to get the 30yr fixed term.

Do not fall in the 5-year-refinance trap. The idea is that in 5 years you can refinance but during this time you would have a lower payment. Each refinancing will cost you some transaction money. If the bank does cover the transaction cost, then you pay it indirectly by accepting sub-optimal terms. Don't let them fool you.

I personally refinanced my only ARM that I had. It had full 4 years of fixed term left on it and I gave up 5.1% to pay now 5.625% (15 year full amortization). During the next 4 years I pay more than before the refinancing, but afterwards I will save a lot - possibly $80,000 in interest.

Also realize, that a LOT of people are in the same situation as you are. Many of them will get another ARM, hoping to sell in 5 years. You already indicated, you want to stay there. Good choice.
Because many people will be forced to sell in 4 or 5 years, when their ARMs are converting, and this will not be good for the prices. It will definitely be a buyer's market then.

Since you have a HELOC on a second home, you may want to consider selling the second home as soon as possible. If located in San Jose, California, it probably does not produce as much rent as investment properties of similar value would do in other states.

In this market, real estate investments should make sense on rental income, with appreciation only being the icing on the cake. Do not expect much more appreciation!

Once you sold that place, use the equity to pay down your $680k loan, or make real estate investments in more profitable states, such as Utah.


Summary:
ARMs used to save a lot of money but they are getting less and less popular. At Washington Mutual option ARMs accounted for 29 percent of their mortgage volume Q3 2005. In Q3 2004 it was 40 percent. IndyMac Bancorp says option ARMs from 39 percent in Q2 2005 to 31 percent in Q3 2005.
More and more of the refinance business - which is already drying up - will be converting ARMs to 30yr fixed terms.





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