
Choosing a program today is not as simple as it was 20 years ago. Due to the highly competitive nature of the mortgage industry new programs are evolving every day to meet the needs of prospective borrowers. The question of choosing an ARM product or a Fixed rate product is one everyone should examine.
The most important factor in comparing a fixed rate to an adjustable rate program is how long you will keep a mortgage.
If you have an idea as to how long you will keep the loan you can then compare the cash flows of each program and determine which program presents the best savings opportunity.
Lets compare a 30 year fixed rate mortgage to a 5/1 Adjustable rate mortgage.
By comparing a fixed rate program and a 5/1 Adjustable rate program we can determine which program is the most advantageous by conducting a break even analysis.
What our analysis will show is that if you are going to keep the mortgage over 7 years you are better off choosing a fixed rate mortgage. Conversely, if you are planning on selling your home or paying off your mortgage under 7 years you are better of with the 5/1 ARM. Note: this example does not take into account future interest rate drops, for this analysis please see the chapter called Why Coose an ARM?
How did we come to this conclusion?
Example: Your obtaining a $150,000 Loan
For this example we will use current interest rates. It will not matter that these rates may not be the rates you are being offered, its the difference in the two that matters and that margin will most likely remain the same (this is a function of the pricing formulas). We will also assume that the closing costs are the same for each program therefore they wouldn't be a factor in our decision.
Program A:
30 Year Fixed Rate Program with a rate of 6.5% and 2 Points.
Program B:
5/1 ARM: Rate 5.875%, 1 point, 2/6 rate caps, 2.75% margin
The BreakEven Analysis
Step1: Determine the payments and the monthly difference
PROGRAM  RATE  PAYMENT 
A: 30 Yr. Fixed  6.5%  $948.10 
B: 5/1 Yr. ARM  5.875%  $887.30 
Mo. Difference   $ 60.80 
Step 2: Determine the cost and difference of the points for each Program
(Note: 1 point = 1% of the loan amount)
PROGRAM  Points  Cost 
A: 30 Yr. Fixed  2  $3,000 
B: 5/1 Yr. ARM  1  $1,500 
Difference   $1,500 
Step 3: Calculate the cost and savings over 5 years with thelower cost ARM program
PROGRAM  Mo. Payment  5 Yr. Cost  Calculation 
A: 30 Yr. Fixed  $948.10  $56,886  $948.10 X 60 pmts 
B: 5/1 Yr. ARM  $887.30  $53,238  $887.30 X 60 pmts 
  
  
Mo. Savings  $ 60.80  $ 3,648  $ 60.80 X 60 pmts 
Point Savings   $1,500  $3,000  $1,500 
  
  
Total Savings   $5,148  $3,648 + $1,500 
Q: What does this mean to you?
A:If you plan on sell this home in five years and trade up to a bigger home you will save $5,148 by choosing the ARM over the fixed rate.
Note: the majority of First Time Home Buyers stay in their first house fewer than five years. Due to this fact most First Time Home Buyer (FTHB) programs are 5/1s.
Q:What if I don't sell my home in five years as I had planned?
A:Good question! There is no way you can predict the exact time that you will be in the home. In choosing a program you need to go with the most likely scenario.
If you had planned to stay in the home for only five years but your plans altered and you are still in the home. Don't worry, here is why:
Back to our example...
After five years your 5/1 ARM will adjust its interest rate. In our example the program had a 2.75% margin over the 1 year Tbill (index), with a 2% interest rate cap per adjustment. This means that your adjusted rate will equal the index plus the margin with a maximum change of 2% per adjustment
Step 4: Calculate the payments during year 6 for both programs
(Note:We will assume a worst case scenario of the maximum rate increase of 2% for the ARM )
PROGRAM  RATE  PAYMENT 
A: 30 Yr. Fixed  6.5%  $948.10 
B: 5/1 Yr. ARM  7.875%  $1,064.10 
Mo. Difference   $ 116.02 
Total additional cost of the ARM program during year 6:
$ 116.02 per month x 12 months = $1,392.24
Step 5: Recalculate savings for the loan at the end of year 6
Formula: 5 year savings minus 6 year cost
$5,148.00 $ 1,392.24 = $ 3,755.75
What if your still in the home going into year 7, 2 years after your original plan?
Let's keep going..
Step 6: Calculate the payments during year 7 for both programs
(Note:like year 6 We will assume a worst case scenario of the maximum rate increase of 2% for the ARM )
PROGRAM  RATE  PAYMENT 
A: 30 Yr. Fixed  6.5%  $948.10 
B: 5/1 Yr. ARM  9.875%  $1,315.57 
Mo. Difference   $ 367.47 
Total additional cost of the ARM program during year 7:
$367.47/mo x 12 = $4,409
Step 7: Recalculate savings for the loan at the end of year 7
Formula:
Savings through 6 years  Year 7 Cost = Net Cost of ARM after 7 yrs.
$ 3,755
$ 4,409
($653.89)
Step 8: What Does This Tell Us ?
The break even is 6 years 10 months, 2 months shy of 7 years. This means that if you were to sell the home and pay off the mortgage after 6 years 10 months the two mortgage programs would have had exactly the same cost. In simple terms: the break even point for the two loans (in a worst case scenario) is just under 7 years.
Conclusion
If you think you may only be keeping the mortgage for 5 years you can save a significant amount of money by opting for an ARM program with a discounted rate. If things don't go as planned you still have another couple of years before you spend he money you had saved. Conversely, if you are going to keep the mortgage over 7 years you are probably better off opting for a more stable fixed rate mortgage program.
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