Thursday, October 9, 2014

ARM comparisons when maturity is 15 years.

ARM comparisons when maturity is 15 years.

A previous post compared benefits and risks of the 5-1 and 7-1 ARM when amortization occurs over a 30-year period.

This post makes the same comparisons for two ARMs with a 15-year maturity.

Question:  Consider a 5-1 ARM with a 2.8 percent initial interest rate and a 7-1 ARM with a 3.2 percent interest rate.   Both ARMs have a 15-year term.    The loan amount is \$500,000.

What are the initial mortgage payments for the two ARMS?

What are the balances when the ARMs reset?

What are loan payments if the reset interest rate goes to 6.0 percentage points?

(These are the same questions that I posed in the previous post.   The only difference is the term of the mortgages   -- 30 years in the previous post and 15 years in this post.)

Tabulations:  The calculations are laid out in the table below.

 ARM Comparisons  15-year Terms 5-1 ARM 7-1 ARM Diff. % Diff rate 0.028 0.032 period 180 180 PV \$500,000 \$500,000 Payment when loan taken out (\$3,405) (\$3,501) \$96 -2.8% FV of loan (\$356,023) (\$296,194) (\$59,829) 16.8% Payment at first reset (\$3,953) (\$3,892) (\$60) 1.5%

The payment difference at time of mortgage origination is trivial -- \$96 or \$2.8%.

The reduction in loan balance is a lot more after 7 years than after 5.  Difference is nearly \$60,000 nearly 17 percent.

Mortgage payments are lower for the 7-1 ARM because the reduction in loan balance is more after 7 years than after 5 years.   The payment difference at time of first payment reset is only around \$60 per month.

Caveats:   The interest rise scenarios presented here understate the risk of ARMs because interest rate resets are annual and rate increases could be very large.   The difference is even more pronounced for the 5-1 ARM because there will be payment adjustments after years 5, 6, and 7.    The payment could go up each year subject to a cap in the contract.

Concluding Remark:  Choosing a shorter maturity (15 years rather than 30 years) can substantially reduce financial exposure for mortgage borrowers who choose ARMS over fixed rate mortgages.   The reduction in exposure to risk stemming from resetting interest rates is especially pronounced for the 7-1 ARM.

I am very interested in 7-1 ARMS that have a 15-year term.   This product by a bank in Missouri appears interesting.

One other difference is that the ARM adjusts for the remainder of the loan.   I believe it is 7-8 rather than 7-1.  (7-1 ARMS adjust annually.)

The rules governing ARMS are really arcane.   There are three main indices.  Payment changes are capped both annually and over the lifetime of the instrument.   There are a lot of details.     I am continuing my work on the ARM primer.