Does It Make Sense To Prepay An ARM?

Headless BankerQuestion: We often hear about the advantages of prepaying fixed-rate mortgages but not the benefits of paying ahead with ARMs. I have prepaid my ARM over time and now enjoy far lower monthly costs because of less principal and lower rates. Why not encourage more people to take this approach?

Answer: You raise an important point. ARMs can be attractive for selected borrowers and prepaying such loans can be advantageous.

You understand and have taken advantage of ARMs as rates have largely declined over time. Whether ARM rates will generally decline further is unknown.

You have also prepaid your loan, generally a good thing.

The issue faced by many borrowers is different. The savings rate in the US was 5.5 percent of personal disposable income in January 2015. That compares with a high of 15 percent at the end of 1975. In many cases tough economic times make prepayments difficult.

ARMs and Risk

ARMs in general shift the risk of inflation from lenders to consumers. That’s not a problem at this time but it could be in the future if rates rise and payments go higher.

For instance, as this is written 30-year fixed-rate financing for well-qualified borrowers is available at this time with interest at roughly 3.8 percent. That’s near the historic low for mortgage rates but what if rates go higher? The fact is that rates can plainly go up: In 1982 mortgage levels reached 17.6 percent.

For those with fixed-rate mortgages rising interest levels are not a financial threat. But for ARM borrowers higher monthly costs can make ownership difficult if not impossible, especially for households where jobs have been lost or income has declined.

If ARMs seem enticing then look at FHA, VA and conventional ARMs. Such loan products have rate caps to prevent payment shock and prohibit prepayment penalties.

However, the fact that ARMs have rate “caps” does not mean monthly costs cannot rise, only that they cannot rise above certain limits. If the thought of bigger payments for principal and interest seems unsettling, then stick with a fixed-rate mortgage — it’s a big-ticket hedge against inflation and one which can typically be prepaid, in whole or in part, without penalty.


Syndicated originally to newspapers nationwide by Content That Works. Revised, modified and updated. Posted with permission.


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