Are ARMs and 40-year mortgage loans good deals for buyers?

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With the dramatic rise in mortgage interest rates, we’re now seeing an increased emphasis on adjustable-rate mortgages (ARMs) along with the reappearance of 40-year mortgages. Here’s what you need to know about the real costs of these mortgage options, over and beyond the amount of the monthly payment.  

When most buyers choose a mortgage, they usually focus exclusively on the amount of the monthly payment and whether they will qualify for the loan. Very few pay attention to the APR or the total amount of interest and fees they will be paying. That choice can be a tremendous mistake. 

Bank or mortgage broker? 

Most buyers will get the best deal by using a mortgage broker rather than a specific lender. To illustrate this point, although we were a private banking client at Wells Fargo at one point, my mortgage broker obtained a much better loan than what Wells Fargo offered us. 

Moreover, having access to multiple lenders is especially important when there is a rate increase, the lender stops making home loans for some reason, or if there is a problem with the appraisal.

Advise your buyers to look at the APR in addition to the interest rate

The following chart from BankRate.com allows borrowers to objectively assess the real cost of their mortgage. Rather than looking at the stated interest rate, smart buyers will consider all the costs associated with the loan, including lender points and fees. 

The APR (Annual Percentage Rate) is the interest rate the borrower pays over the life of the loan that considers points, fees and other lender charges. It can be a useful way to compare not only the cost of mortgages but also credit cards and other investment products. 

Just keep in mind that the APR calculates the impact of fees as if they were paid over the full term of the loan (typically 15 or 30 years for a mortgage). That means it can be biased in favor of loans that charge higher fees in exchange for a lower interest rate. Also, because rates on ARM loans can go up, be careful about comparing APRs on fixed-rate mortgages and ARM loans.

To illustrate how this works and which loan products have the lowest costs, always compare the APRs. Examining the chart above, here’s what to note:

• Usually, the shorter the loan term, the better the interest rate is. Nevertheless, the 15-year fixed rate mortgage in this case was less expensive than the 10-year fixed rate mortgage.  
• The two lowest interest rates were for: 
• The 5-1 ARM with an interest rate of 5.77 percent
• The FHA 30-year fixed rate at 6.15 percent.

Nevertheless, these two products have the most expensive APRs. For the 5-1 ARM the APR was 7.45 percent. For the 30-year FHA fixed rate loan, 7.07 percent. That’s a huge difference over the life of the loan.  

• Also note that in this example, the fixed-rate conventional and jumbo loans had the lowest spread between the interest rate and APR (0.02 percentage points).   

Consequently, always advise your buyers to either have their mortgage broker run the APRs on each loan type they may be considering or to use a resource such as Bankrate.com that provides a snapshot of various types of loan products currently available.  

Just keep in mind the shortcomings of the APR calculation — it assumes you will keep your mortgage for its full term, and it can’t predict what the rate of your ARM loan might be in the distant future.

As a rule of thumb, if you don’t plan on keeping your mortgage for at least seven years, the loan with the lowest APR isn’t necessarily the best deal, because it often takes at least that long to recoup your upfront costs when buying down your rate. And if you’re looking for a mortgage where the lender pays your settlement costs in exchange for you accepting a higher interest rate, you can also expect that to impact the APR.

When ARMs may be a better choice than fixed-rate loans

There are a variety of situations where an ARM can be a better choice than a fixed-rate loan. Here are six examples. 

Lower initial interest rate

The initial interest rate on an ARM is typically lower than that of a fixed-rate mortgage.  This translates into much lower monthly payments the first few years of the loan. This must be weighed, however, in terms of the APR because lenders often get a big chunk of their upfront profits in closing costs.  

Lower initial monthly payments

When people purchase a home, they usually have a significant number of additional expenses, including moving costs, furnishings, repairs, etc. Having a lower initial payment can help them cover other high-priority financial obligations rather than getting stuck paying 18-28 percent interest if they put these costs on their credit cards. 

An ARM may allow them to buy a better house 

Lower initial payments allow borrowers to qualify for a larger loan amount, enabling them to buy a more expensive house than they could with a fixed-rate mortgage.

ARMs allow borrowers to take advantage of potential interest rate drops

When the Great Recession hit, I remember our fixed-rate mortgage was at 12 percent and rates dropped to under 7 percent. While we were stuck with our fixed-rate mortgage (and our lender refused to give us a loan modification), those with ARMs watch their mortgage rates plummet.  

Short-term homeownership

Many first-time buyers buy “starter homes,” a place to get their foot into the market and to start claiming the benefits of owning vs. renting. Two examples include:

• An ARM can be perfect for the buyer who is leading a nomadic lifestyle and wants to experiment with living other places in the country. 
• The buyers may have purchased a condo when they were first married and now that they’re expecting a baby, they want a yard as well as a great school district. 

Increased earning power

Young professionals who expect to earn significantly more money as they advance in their careers may choose an ARM because they will have the future income to handle the increased payments.  

The downside of ARMs is that if interest rates increase quickly as they have done recently or if the borrower stays in the home longer than they had planned, they can be stuck with a much higher loan rate as compared to having taken a fixed rate loan. 

40-year mortgages are a complete and total rip-off

While most lenders don’t offer them, you may be able to find a 40-year mortgage from providers that specialize in “non-Qualified Mortgages.” Because they’re often riskier, non-QM loans aren’t eligible for purchase or guarantee by mortgage giants Fannie Mae and Freddie Mac.

The chart below illustrates the real costs on a 40-year mortgage and how what seems like a lower monthly payment for the borrower actually is not. 

• The lure of the 40-year mortgage is lower monthly payments. For example, the payments on the 30-year fixed rate mortgage at 7.0 percent are $1,996 per month for the 30-year mortgage vs. $1,864 for the 40-year fixed rate mortgage. 
• But here’s the catch. If the borrower stays in the property for 40 years, they will pay an extra $176,344 in additional interest over 480 months, an extra $367.38 per month. Rather than getting a lower payment, the borrower is getting a huge increase in how much interest they’re paying on average each month over the life of the loan. 

The bottom line is that focusing exclusively on monthly payments can be deceptive; buyers should consider the total cost of any loan they are considering taking, including interest over the life of the loan before deciding on which loan is right for them.