ARMs for the long run How to lower costs and alleviate risk

An ARM will often save you money if you plan to sell within five to seven years, but you also might save money over the longer term. Here's why.

Imagine you must choose between a 30-year fixed-rate loan at 8 percent and a 7/23 that starts at 6.75 percent. You want to borrow $100,000. With the fixed-rate plan, your payments will cost $733 a month. With the 7/23, you'll pay $648. For at least the first seven years, you'll save $85 a month, for a total of $7,140.

Instead of pocketing this monthly savings of $85, though, add it to your monthly mortgage payments. Even though you're only required to pay $648 a month, you go ahead and pay $733 ($648 + $85 = $733). This tactic causes you to pay down your outstanding mortgage balance much faster. By making extra payments, your mortgage balance after seven years would fall to approximately $83,000. On the other hand, your mortgage balance with the fixed-rate plan at 8 percent would drop to only $92,480. Obviously, if you sell at this point, you're way ahead of the game with the ARM.

But what if you don't sell? As long as your new adjustable rate stays below 9.5 percent, your monthly mortgage payments won't amount to any more than $740—about the same as you've been paying. At 10.5 percent, your payments would just increase to $798 a month. Now, what if interest rates are lower when your loan adjusts after seven years? Not only will you have accumulated an additional $9,480 in equity, but your monthly payments can decrease.

These figures are illustrative only. Because the relative costs of ARMs and fixed-rate loans change frequently (recall the discussion of interest rate spreads on p. 45), you must work numbers with your mortgage loan advisor that are current at the time you buy your property.5 Still, this basic fact holds true: For some buyers, the right ARM can add thousands of dollars in equity as compared to a 30-year fixed-rate mortgage.

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