Many homeowners and potential homeowners may be familiar with adjustable rate mortgages, or ARMs. Perhaps some of them might think that hybrid loans like the 3/1 or 5/1 ARM carry a higher risk, given the fallout from the mortgage crash in 2009. However, ARMs have changed a lot in the last few years; one of the problems with some ARMs in the past was that some of them allowed for negative amortization.
Today, that is not allowed. An ARM as of 2016 is fixed for a certain time period – usually three or five years – and then will adjust based upon current market conditions. Today’s ARMs also have maximum caps on the top interest rate you will have to pay.
An ARM can make a lot of financial sense for many homeowners, including millennial homebuyers. Let’s examine some of the details and advantages of 3/1 and 5/1 ARMs.
What is a 3/1 and 5/1 ARM?
The interest rate on a 3/1 or 5/1 ARM loan will be fixed for either three years or five years. After the fixed rate period expires, your rate can go up or down, depending upon the market. But as noted above, you do not have to fear your rate skyrocketing 10 points.
There is a cap in place. Usually, a rate adjustment cap will be in the area of 5% above your current rate, or possibly 2% or 5% per each adjustment period. So, if your rate is 3.5%, your adjusted rate may not go above 2% or 5% per year, with a total maximum of 5%. So the worst case scenario on this loan will be 8.5%.
Here are some good reasons why millennial homebuyers may want to opt for a 3/1 or 5/1 ARM:
#1 Interest Rates Are Lower
A major advantage of an ARM is that you will pay a considerably lower rate than a fixed rate mortgage. So, you will have a lower payment during the fixed period. This is advantageous for many young buyers because they are probably just starting out in life. They may have a lower income in their 20’s and want to save on their monthly payments.
If the interest rate on a 5/1 ARM is .5% lower than a fixed rate mortgage, this could potentially save you $75 per month or even more!
#2 Good Loan for a Starter Home
Many young millennials are buying their first home just a year or two out of college. This could well be a starter home for them. After you have worked for five years, you may decide to move into a larger home. So, you could well sell your home before the rate ever adjusts. If you really do not think you will be in the house in five years, then the 5/1 ARM might be a good fit for you.
#3 Savings Can Be Used for Other Purposes
Many millennials have learned from the financial mistakes of their parents in the mortgage meltdown. Many of them may be able to exercise more financial discipline. If you can take the money that you are saving every month with your ARM and invest it into the stock market or real estate, you may end up with a nice nest egg!
#4 Many Millennials Move a LOT
There was a time when many families stayed put in one city or one home for life. Times have changed a great deal in the last 30 years. Today, many young home-buyers are moving around every few years. If you are going to be selling your home in a few years and possibly moving to another city, getting a 3/1 or 5/1 ARM is logical.
#5 Most Millennials Will Refinance Anyway
The typical thinking with mortgages is to get a fixed rate mortgage because it provides you with ‘security.’ However, the majority of Americans either move or refinance every 5-7 years.
So, what is the point in paying a higher interest rate for ‘security’ that you are never going to actually use? In this case, it really makes a lot of sense to just go with the lower interest rate on an ARM, as you probably will end up selling the home or refinancing in a few years anyway.
#6 Millennials Weren’t Stung By the Mortgage Crash
Most millennials were too young to have been affected by the mortgage crash, which is a good thing. That was a rough time for many homeowners. Many people who went through that period may have a fixation with a fixed rate mortgage. That is totally understandable, but you should not prevent yourself from enjoying the benefits of a substantially lower interest rate on your home based upon a once in a lifetime financial calamity that occurred in 2008 and 2009.
For most of us, who were not alive in the Great Depression that was the worst financial situation we will ever live through. Just because that financial mess happened, does not mean that today’s millennials should let it affect their thinking on their current mortgage.
For many home buyers, a 3/1 or 5/1 ARM makes great financial sense. The only reason to not do an ARM for many people is that it simply will make you worry. If you are one of those people, then you may want to just get a fixed rate and not worry. But for people who are not overly worried about ‘security’ that they may never actually enjoy, an ARM can be a great money saver in the long term.