The prime lending rate has been kept static for so long, it’s not surprising that we are not sure what will be the impact of the Federal Reserve’s recent decisions to raise it. Since the economic troubles of 2008, the Fed has kept a tight grip on the rate, having it go unchanged for seven years. It was set at 3.25 percent in December of 2008 and remained that way until December of 2015, when it was raised to 3.50 percent. It spent a year at that rate before being raised to 3.75 at the Fed’s meeting in December of 2016. At its March, 2017 meeting, the Fed raised it once again, this time to 4.00 percent.
What does this mean for the average consumer looking to get a traditional, 30-year mortgage? The increased interest that has come with the rise in the prime means it might be time to look at alternative means of mortgaging your next home purchase.
The Adjustable Rate Mortgage (ARM) of today is not the same as the ones that dominated the marketplace in the earlier part of the century. Because of the housing crisis of the last decade, many of the problems have been alleviated with these types of loans. Negative amortization and prepayment penalties are a thing of the past. What is left instead is something much more consumer friendly.
The concept is that the rate on your loan changes with the changing marketplace, as opposed to being locked in for 30 years at the rate on the day the loan was finalized, as with a traditional loan. ARMs should be especially appealing to home buyers who don’t plan to stay in one place very long. They also have appeal to those who have good-but-sporadic income and those who know that their income is going to be increasing in the near future.
What are the up- and down-sides of ARMs?
Because you are taking the risk against higher rates at a later date, the lender will usually start you off with a lower initial rate. This will be reflected in your payments, which will be lower.
ARMs can come with adjustment caps. The initial adjustment cap limits how much of an increase can be levied the first time there is a change. Common limits are two or five percentage points higher than the starter rate. A subsequent adjustment cap covers the rest of the life of the loan. The most common figure here is two percent, so that your loan can never be raised by more than two percentage points above the previous rate. There is also a lifetime adjustment cap. This limits the total increase allowed on the loan over the course of its full duration. Five percentage points is typical in these cases, but higher caps do exist. So that nothing will come as a complete surprise, have your lender calculate the highest possible payment you will ever have to make on your ARM.
These are some typical ARM programs:
- 10/1 ARM: There is fixed rate for 10 years after which it adjusts every year (up to the cap, if there is one).
- 7/1 ARM: A fixed rate for 7 years, after which it is adjusted annually (up to the cap, if any).
- 1-Year ARM: Here, the rate is fixed for only one year, after which it adjusts annually (up to its cap, if it has one).
Make no mistake about it: an ARM is a gamble of sorts. If the prime lending rate spikes, you could be looking at a substantially higher monthly payment. In the bad old days of the early 21st Century, this sort of thing contributed to many people losing their homes through foreclosure, but the laws have been modified to make this less likely. Consider, too, how restrained the Fed has become in the wake of that debacle. While rates have gone up lately as discussed above, a big spike would not fit their pattern of behavior over the last decade.
Risk and Reward with Interest-Only Loans
Another work-around on the traditional 30-year, fixed-rate mortgage is the so-called interest-only loan. The way it works is that for the first years of the loan, the borrower is only paying down the interest. Naturally, this can result in dramatically smaller monthly payments. The catch is that, eventually (probably about 10 years into the loan), the principle will come due and those payments will increase. It’s an appealing loan to those who believe their income is going to improve over time, someone who is likely to move during the interest-only period or those who are nearing retirement and are planning to move to a smaller home within a few years and offload the house on which they’ve got the interest-only mortgage.
Those who are especially savvy take the money they’ve saved – the gap between what they’re paying every month and what they would be paying on a traditional mortgage – and invest it wisely. That way, when it comes time to start paying the principle, they’ve got a sizable savings to help handle the burden.
Which is why the interest-only option is not for everyone. It is human nature to become accustomed to situations and start believing that how things are at present is how they’re going to remain. For many, it will be too tempting to think that the lower initial payments that come with an interest-only loan are a way of life and that there is no increase coming years in the future. Unfortunately, their interest rate is subject to upward adjustments and the lender is going to want that principle paid for as well. It is not a strategy for the undisciplined.
Rates Are Still Low
Consider some historical perspective: Even though rates have been raised three times since the seven-year flat-line of 2008 to 2015, they are still relatively low. Much higher rates have been more typical over the last 45 years, so you are still paying a fairly low interest rate on any mortgage you get, be it one of the alternatives we’ve discussed here, or on a traditional 30-year, fixed rate program.