August 29, 2023 • 22 mins
Are short-term savings using an adjustable rate mortgage worth the risk of rate hikes? In this podcast, we cover how adjustable rate mortgages (ARMs) work, how they differ from fixed-rate mortgages, and the reality of their adjustment periods.
James uses a real-life scenario to dive into the comparison of adjustable and fixed-rate mortgages. Learn how to plan for the worst-case scenarios and evaluate the benefits and drawbacks of each option.
Questions answered:
Is it better to get a fixed rate mortgage, or is it better to get an adjustable rate mortgage?
What is the risk versus reward?
Timestamps:
0:00 Intro
3:10 Buying a home
5:18 How ARMs work
7:24 Why use an ARM?
10:11 What's the risk?
14:07 When not to get an ARM
16:15 When to get an ARM
18:50 Other considerations
20:21 Analysis
21:06 Outro
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Transcript
Episode Transcript
Available transcripts are automatically generated. Complete accuracy is not guaranteed.
Speaker 1 (00:00):
High interest rates have driven the cost of
mortgages up by 40-50% or moreover the last couple of years.
This, combined with arelatively stable housing market
, has made buying a homesignificantly more challenging.
So this challenge now has manypeople wondering if they should
use an adjustable rate mortgageto keep their monthly payments
down.
But is that really a good idea?
(00:21):
In today's episode, we'lldiscuss the pros and cons of
adjustable rate mortgages andhelp you decide if one is right
for you.
This is another episode ofReady for Retirement.
I'm your host, james Cannell,and I'm here to teach you how to
get the most out of life withyour money.
And now on to the episode.
(00:42):
Today's episode is based upon alistener question, and what
you'll notice as I read off thisquestion is some of the
interest rates I'm referencingare very clearly not the
interest rates we have today.
However, the principle behindthis listener's question is
still very much the same, andthat comes down to what is
better in today's interest rateenvironment.
Is it better to get a fixedrate mortgage or is it better to
(01:04):
get an adjustable rate mortgage?
I'll dive in more to that injust a second, but before I do
so, want to read the question.
This question comes from John,and John says my wife and I are
looking to purchase a new home.
The mortgage broker isrecommending a seven or 10-year
arm.
Arm, by the way, stands foradjustable rate mortgage.
The interest rate on theseven-year arm is 4.25% and the
(01:25):
interest rate on the 10-year armis 4.5%, while a 30-year fixed
mortgage is 5.25%.
Does the savings of one of theadjustable rate mortgages
justify taking the riskassociated having to refinance
at a future unknown rate?
Does the answer change asinterest rates increase further?
I would hope we would still bein our house at the end of those
arms adjustable rate mortgages.
(01:47):
And that is from John.
Well, john, thank you for thatquestion and, yes, the interest
rates that he's referencing.
This is very clearly a questionthat was submitted several
months ago, so those interestrates are no longer the current
rates that we're hearing today.
But the reality is, by the timeyou're actually listening to
this, interest rates willprobably be a little bit
different, and in six months or12 months or 18 months, interest
rates will be a little bitdifferent.
(02:08):
So, instead of just looking atthose specific rates, what we're
going to do today is walkthrough a framework of how
should you think about this andhow does that framework stay
consistent even as the actualinterest rates will change going
forward?
Now, before we jump in, I alwayslike to highlight the review of
the week.
Thank you, by the way, to allof you who have taken the time
to leave reviews.
This review comes from usernameSlilonic, and Slilonic leaves a
(02:32):
five star review and says Ireally appreciate this podcast
for bringing up so manydifferent client scenarios in
the many ways to think aboutpossible solutions.
I'm an aspiring financialadvisor and I'm very early on in
my career.
This podcast is a greataddition to my daily routine to
help educate me on financialplanning.
I'm currently enrolled to getmy bachelor's degree in CFP
certification and listening tothis podcast has really helped
(02:53):
me to solidify everything I'mlearning.
Thank you, james, for all thethings you talk about and the
excellent way you go aboutexplaining it all.
And that is the end of thereview.
Well, slilonic, thank you verymuch for that review.
I appreciate it.
Best of luck with all thestudying.
It's a wonderful career, so I'mglad this podcast has been
helpful as you've been studyingto enter it.
So let's now jump right intothe content.
When you go to buy a home andthis could be the first time you
(03:15):
buy a home.
It could be because you'rebuying a rental property.
It could be because you'reselling your current home and
relocating somewhere else.
All that is going to be thesame in terms of what we're
talking about today.
When you go to acquire that newproperty, how do you finance it
?
Yes, if you have all cash thisconversation is a little bit
irrelevant but if you're goingto take out some type of a
mortgage, you need to understandwhat those mortgage options are
(03:38):
and you need to understandwhich one might be best suited
for different types ofsituations.
So when you look at mortgages,traditionally, the most common
option is a 30-year fixedmortgage.
You borrow some, some of themoney from the bank.
The bank says here's theinterest that we're going to
charge you for the life of theloan and you have one single
fixed payment for all 30 years,until your mortgage is fully
(03:58):
paid off.
You could have the same thingfor 15-year mortgages or even
20-year mortgages, where you geta rate and what the bank does
is they amortize your payment,saying, based upon this interest
rate and this amount that we'reletting you borrow, here's your
payment that you're going topay us for the end of the term
or until the end of the term,whether it's 15, 20, 30 years.
So those are standard mortgageoptions.
Those are the most common.
(04:18):
But there also are alternativemortgage options.
You could have interest onlymortgages, where you borrow some
of money and you just payinterest on that mortgage until
some balloon payment is due oruntil you've fully paid it down.
You could also have adjustablerate mortgages.
In adjustable rate mortgagesthis is what John is referring
to in his question, and the wayan adjustable rate mortgage
works is they might say James,you can borrow money from us and
(04:42):
we're going to give you oneinterest rate for maybe five
years or seven years or 10 years.
And if you hear someone say I'mgetting a five-one arm or a
10-one arm, what that's sayingis that first number is how long
is the initial interest rategood for, and then one is the
frequency so every year, thatthat interest rate can be
(05:03):
readjusted, and we'll talk aboutthe method by which it does
that in just a bit here.
But when you get an adjustablerate mortgage, what you're doing
it for, the reason you're doingit is you're getting a lower
interest rate than if you wereto go get a 30-year mortgage for
that same amount.
So let's real quickly workthrough how adjustable rate
mortgages work, becauseunderstanding this although many
of you might already know, butunderstanding this is kind of
(05:25):
fundamental to knowing.
Should I go with this optionversus should I go with a more
traditional 30-year fixed typemortgage option?
So here's the quick rundown onhow adjustable rate mortgages
work.
You'll typically see somethinglike five-one arm or seven-one
arm and, as I mentioned before,that first number is how long
the mortgage is fixed for.
So if we use a five-one arm andagain arm stands for adjustable
(05:48):
rate mortgage, that means thatfor the first five years alone
you're going to have a fixedinterest rate.
The second year, so in thefive-one, the one indicates how
many times per year the interestrate can be adjusted after that
initial time of the interestrate being fixed.
So after the first five yearsin this example, then the
interest rate could go up orcould go down, but it goes up or
(06:10):
down based upon some index ratesuch as the London Inner Bank
Offer rate, so LIBOR, forexample.
So what you're going to have isthe mortgage company will say
we're going to adjust your rateat LIBOR plus 3%, for example.
So if LIBOR, so if the LondonInner Bank Offer rate which is a
rate that you're never going tobe able to borrow money at, but
(06:31):
it's kind of like the rate atwhich all other rates or many
other rates are based on ifLIBOR is at 3% and if the margin
on your loan is at 3%, thenyour rate is going to be 6%
after the initial five-year termis up.
If LIBOR goes up to 4%, thenyour rate is 7%.
So it's still that 4% LIBORplus 3% margin.
(06:55):
That's the adjustable part ofthe name.
So the amount of the adjustablerate mortgage can then adjust
each year after the initialfixed time period, and then
there's typically some cap onwhat's the highest this rate
could go to over the life of theloan.
So, for example, maybe the capis 8% or 9% or 10% or whatever.
It is essentially telling youif you get this mortgage, your
(07:18):
rate will never go above 10%,even if LIBOR were to go much
higher in an extreme example.
So, with that basicunderstanding, why would anyone
select an adjustable ratemortgage If you're now at risk
of having your mortgage paymentgo way up, if interest rates go
way up, why on earth wouldanyone elect this?
Hey, everyone, it's me againfor the Disclaimer.
(07:38):
Please be smart about this.
Before doing anything, pleasebe sure to consult with your tax
planner or financial planner.
Nothing in this podcast shouldbe construed as investment, tax,
legal or other financial advice.
It is for informationalpurposes only.
Well, you would choose anadjustable rate mortgage because
for that first five years, orseven years or 10 years,
whatever that first number is inthe five, one or seven, one or
(08:00):
10 one title of the loan theinterest rate is going to be
lower than it otherwise wouldhave been if you had elected a
third year mortgage.
So let's take an example ofwhere rates might be today.
Now, granted, all of theserates are going to depend, in
terms of you getting an actualmortgage, on your credit score,
the loan amount, other factors,where our current interest rates
.
But just for the sake ofexample, let's assume that you
(08:22):
could go out and you're tryingto borrow $500,000 to buy a home
.
Well, you could go get a 30year fixed mortgage and let's
assume the interest rate on thatis 6.75%.
Or you could go get anadjustable rate mortgage and the
interest rate on that is 5.5%.
Well, you can see right off thebat why someone might at least
be intrigued by this adjustablerate mortgage option, that
(08:45):
interest rate is lower than the30 year fixed rate.
Now let's compare the paymentsagain, assuming a $500,000
mortgage, if we're just lookingat the principal and interest
portion of the mortgage, soexcluding property taxes or
insurance, so excluding any ofthe escrow part a 30 year fixed
mortgage at 6.75% on a $500,000loan, your monthly principal and
(09:06):
interest payment would be$3,243 per month.
If you were to get that same$500,000 mortgage but you used a
5.1 arm at 5.5%, well now yourpayment would be $2,839 per
month.
So as you look at these numbers, the principal interest payment
for the 30 year fixed mortgageis 14% higher than the arm was
(09:29):
and the adjustable rate mortgagewas.
So that's a pretty dramaticdifference.
As you're doing your homeshopping and you're trying to
think, where do we want to buynext?
Where's our family going tolive A 14% difference and a
fairly large expense that addsup.
So you look at that adjustablerate mortgage and that's very
appealing to say can I get amortgage rate that saves me a
few hundred dollars each month?
(09:50):
And now here's the thing.
If we knew the interest rateswere only going to get lower
between the time we take outthat loan and the time that loan
is paid off.
The adjustable rate mortgage isthe way to go.
You're going to start out witha lower rate, and that lower
rate is going to continue evenafter the initial fixed rate is
up.
After that 5, 7, 10 years,whatever it might be.
(10:10):
What is the risk, though?
So why wouldn't you moveforward with that?
Well, the risk very clearly putis that interest rates go up.
So let's take a look at that asan example.
Assume you get a 5, 1 arm on a$500,000 loan at the rates we
just looked at.
So you get a 5.5% interest rate, when you otherwise would have
had a 6.75% fixed rate if yougot a 30 year loan.
(10:33):
Well, let's assume that afterfive years is up, interest rates
have gone up and your new rateis 7.25%.
What happens is your mortgagecompany takes your remaining
balance, and you would have paidsome of your mortgage down by
that point.
But they take your remainingbalance and they re-amorotize it
every single year, assumingthat an adjustment was made to
the interest rate.
(10:53):
So, based upon, in this example, still having 25 years left to
pay this off, the mortgagecompany would say what's the new
loan amount?
Well, if it started at $500,000,assuming you made the minimum
payment of $2,839 per month forthe first five years, your
actual balance would be down to$462,300 at the end of those
(11:15):
five years.
They would then take that newbalance, re-amortize it at 7.25%
and now your payment would goup to $3,342 per month.
Now that's an 18% increase, sothat if you're looking at it,
you may not be able to affordthat.
That's the risk.
If your mortgage payment all ofa sudden was almost 20% higher,
would that still fit in thebudget or would you be forced to
(11:39):
move or at least cut someexpenses pretty dramatically?
Now some of you might be sayingwell, james, sure that's an 18%
increase, but that new paymentis only $100 more per month than
the 30-year fixed mortgage.
Otherwise it would have beenBecause, again, the new payment
on the adjustable rate mortgage,after it re-amortizes assuming
a 7.25% rate your new payment is$3,342.
(12:04):
The initial 30-year fixedmortgage was at $3,243 per month
.
So you can look at that and say, oh my gosh, in that case and
now I'm just making up thesenumbers that case it could be
worse, that rate could be higher.
But in that case you might lookat that and say worst case
scenario, or maybe common casescenario is my payments $100 per
month higher than what it wouldhave been with a 30-year fixed
(12:26):
from the beginning.
You might look at that and saythat's not so bad, or you might
look at that and say, well, Icouldn't afford the 30-year
fixed rate to begin with, letalone anything higher than that
rate.
So this is very much where youhave to understand your own cash
flow and your own personalsituation and your own
contingency plans when you havea mortgage rate that's not fixed
(12:47):
and that could go higher, whichwould lead to higher payment
amounts.
So, put very simply, whenyou're asking should I use a
30-year fixed mortgage or shouldI use an adjustable rate
mortgage, you just have to beaware of the risk and that's the
risk.
The risk is interest rates cango up and if interest rates go
up, your payments go up.
So if you're getting and ifyou're reaching for that
(13:07):
adjustable rate mortgage becauseyou say, oh, I just can't
really afford that 30-year fixedrate, but I could afford the
adjustable rate mortgage and I'mjust hoping the interest rates
will be lower in five years orseven years when that initial
term is up, that may be wishfulthinking.
Remember, if we just look backat 2022, many economists at the
beginning of that year assumethat rates would probably go up
(13:29):
by about half a percent in 2022.
Instead, they increase by over4%, one of the most actually the
most dramatic increases in thefederal fund rates that we've
had in the history of theFederal Reserve, in terms of how
fast rates rose.
Now will they keep going up,will they go down?
How long will they stay high?
How long would they maybe staylow?
(13:49):
It's just a guessing game.
No one really knows withcertainty.
So if you're going to go withthat adjustable rate mortgage,
it's not necessarily the worstthing in the world to do so, but
make sure you're well aware ofthe possibility that your rate
might be higher in five or sevenor 10 years than lower.
So don't go into this and getan adjustable rate mortgage if
(14:11):
the only way you could possiblyafford it is if interest rates
happen to be lower in five orseven years than they are today.
If that's the case, not onlyare you setting yourself up for
potential disaster, but, moreimportantly, you're going to
have a huge amount of anxiety ina year, two years, three years,
four years, as you know thatyour ability to maintain your
home, your ability to house yourfamily is contingent upon
(14:34):
something that's completely outof your control.
Now, this is where there'sother factors that you have to
look at.
So here's those other factors.
Let's assume that you'reconsidering mortgage options and
there's a pretty significantspread between an adjustable
rate mortgage and, say, a 30year fixed mortgage, and by
spread I mean the interest ratedifference is pretty significant
.
Well, if you're considering andI'm just going to use a 7-1 arm
(14:56):
in this example if you'reconsidering a 7-1 arm versus a
30 year mortgage and you knowwith certainty you're not going
to be living in that home afterseven years, an adjustable rate
mortgage probably makes a lotmore sense.
You're essentially locking inthat interest rate and you know
that you're not going to be inthe home after that initial
interest rate stops being fixedand begins to adjust based upon
(15:18):
current interest rates.
So if that's the case, anadjustable rate mortgage might
make a lot of sense.
Now I would give you anotherpiece of advice there, that if
you know for certain you're notgoing to be in a home longer
than five or seven years, doesit really make sense to buy that
home to begin with.
If the home is going toappreciate quite a bit then?
Yes, but there's a lot ofstudies and if you actually run
(15:39):
some of the numbers, there's alot of costs and your first few
years of home ownership.
It's everything from closingcosts to the fact that when you
get a mortgage whether it's anadjustable rate mortgage or
fixed the first several years ofpayments are primarily interest
payments, which means you'rereally not building equity with
most of your payment.
There's property taxes.
There's a broker commissionyou're going to pay when you
(16:00):
sell the property.
There's maybe new maintenancecosts when you first move into a
place, when you start to lookat it.
The first few years the chancesof you actually making money if
you know for certain you'regoing to have to sell within,
say, five years aren't actuallythat high.
What you'd have to be dependingupon to make money to buy a
property and quickly sell it isfor the appreciation of property
(16:20):
to increase rapidly.
So are you either doingsomething internally and
renovating the home to make itmore attractive, more valuable,
or do you get to participate inmarket forces driving the price
of that home higher?
If that's not the case, thenyou may not be wanting to buy
that home.
If it's just for a short-termhold anyways.
So that's for a separateepisode.
But point number one is if youknow for certain you won't be in
(16:43):
a home for a long time and ifyou know for certain you are
actually going to buy it.
That's when an adjustable ratemortgage might make more sense.
The second case where anadjustable rate mortgage might
make more sense is you knowyou'll have the means when the
adjustable rate actually startshappening.
So after the fixed rate is upand the rate starts to adjust
after the five-year, seven-yearterm, you may be in a different
(17:05):
financial situation.
I'll give you a perfect exampleof this.
There was actually a couple ofdifferent clients I was talking
to recently, both acquiring newhomes because they're moving to
different parts of the country,and we had the conversation of
how do we finance this?
There's going to be a goodportion as a down payment, but
for the remainder, is itadjustable rate mortgage?
Is it interest only?
Is it a fixed conventionalmortgage?
(17:27):
And as we started to run thenumbers, we weren't just looking
at well where interest rate'sgoing to be, what's the payment
going to be, all those things.
Those are absolutely important.
But we were looking at our bigpicture financial plan and one
of them in these instances hadpretty significant deferred
compensation payments being paidout over the next five to seven
years.
(17:47):
Now why does that matter?
Well, in his situation wedetermined it probably makes
most sense to get an adjustablerate mortgage to lock in a lower
interest rate because, worstcase scenario, if interest rates
do skyrocket, what you've gotsome pretty significant deferred
comp payments come in in.
Those payments can simply beused to pay off the mortgage at
that point.
(18:07):
So that's an example of where Iwould say understand what your
financial situation will looklike at that time.
If you have the income tosupport a higher payment once
interest rate adjusts, or if youhave liquidity or assets to pay
off the mortgage, if youdetermine that's best if the
interest rate adjusts, thenyou're in a much safer position
than if you buy a home and youreally don't have the means to
(18:30):
pay a higher mortgage.
You don't have liquid reservesto pay down the mortgage balance
if needed.
And now you're in a tough spotwhere, if interest rates go up
and you have an adjustable ratemortgage, you're forced to make
some very difficult decisions,one of which might be selling
the home and moving somewhereelse that you could afford.
So make sure you know yoursituation.
Another example of where yoursituation really ties into this
(18:53):
is maybe you have some prettysignificant expenses, maybe
you're paying for children'scollege, maybe you have a
vacation home or rental propertythat the mortgage is going to
be paid off soon, say within thenext five years.
Well, if that's the case andyou've got some pretty
significant expenses falling off, after five years you could
afford for a little bit of anincrease or maybe even a quite
(19:13):
substantial increase worst casescenario to your mortgage
payment after five years, oncethat interest rate adjusts on
your adjustable rate mortgage.
So it's all about understanding, not only comparing the options
between adjustable ratemortgages and your fixed rate
mortgage options, but alsounderstanding your specific
situation when that adjustmenttime comes.
(19:34):
Would you be in a position topotentially have to pay a
mortgage that's 10%, 20%, 30%higher?
If the answer is yes, well,there's less risk in getting
that adjustable rate mortgage.
If the answer is no, now all ofa sudden, there's a lot of risk
in getting that adjustable ratemortgage.
So finally, when you look at allthis, if you knew a certainty
(19:55):
that interest rates are going todrop and that you could
refinance once that adjustmentperiod happens, there's really
no reason to not get theadjustable rate mortgage, but
again, we don't know whatinterest rates are going to do.
Is it likely the interest rateswill drop at some point?
A lot of people certainly sayso, but again, keep in mind that
nobody was forecasting rates togo up like they did in 2022,
(20:16):
where the Federal Reserveincreased rates the fastest it
ever had before.
So when you look at this, itseems like a fairly simple
analysis, and to an extent it is.
When you're just comparingmortgage rate options, you can
run the numbers on a fixedmortgage, you can run the
numbers on an adjustable ratemortgage to see what that
payment looks like, and then youcould run it to see what might
(20:36):
the payments be on an adjustablerate mortgage, based upon what
I like to call worst casescenario.
What's the most?
They could go up after fiveyears or 10 years or 15 years,
based upon the terms of the loan, and then look at your personal
financial situation.
If that worst case scenariowere to happen even if it's
unlikely, you could run thenumbers like that Would you be
in a position to be able to rollwith it, or would you be in a
(20:58):
pretty tight financial situationwhere it would cause you a
great amount of financialdistress and even lead to a
potentially very negativeoutcome.
So that is it for today, john.
I appreciate that question.
For all of you who have leftreviews, I appreciate you doing
so.
If you have not already done so, please take a moment.
Click five stars if this showhas been valuable to you at all,
and also an announcement.
(21:19):
It's been this way for a coupleof weeks now, but we are on
YouTube.
The YouTube channel used to beunder root financial.
Just now, just under my name,james Cannell, c-o-n-o-l-e.
So check out this podcast.
Also check out other greatvideos on our YouTube channel
and again, that channel name isJames Cannell.
So that's it for today.
Thank you, as always, forlistening and I'll see you next
time.
Thank you for listening toanother episode of the Ready for
(21:43):
Retirement podcast.
If you want to see how rootfinancial can help you implement
the techniques I discussed inthis podcast, then go to
rootfinancialpartnerscom andclick start here, where you can
schedule a call to one of ouradvisors.
We work with clients all overthe country and we love the
opportunity to speak with youabout your goals and how we
might be able to help.
And please remember, nothing wediscuss in this podcast is
(22:03):
intended to serve as advice.
You should always consult afinancial, legal or tax
professional who's familiar withyour unique circumstances
before making any financialdecisions.
High interest rates have driven the cost of
mortgages up by 40-50% or moreover the last couple of years.
This, combined with arelatively stable housing market
, has made buying a homesignificantly more challenging.
So this challenge now has manypeople wondering if they should
use an adjustable rate mortgageto keep their monthly payments
down.
But is that really a good idea?
(00:21):
In today's episode, we'lldiscuss the pros and cons of
adjustable rate mortgages andhelp you decide if one is right
for you.
This is another episode ofReady for Retirement.
I'm your host, james Cannell,and I'm here to teach you how to
get the most out of life withyour money.
And now on to the episode.
(00:42):
Today's episode is based upon alistener question, and what
you'll notice as I read off thisquestion is some of the
interest rates I'm referencingare very clearly not the
interest rates we have today.
However, the principle behindthis listener's question is
still very much the same, andthat comes down to what is
better in today's interest rateenvironment.
Is it better to get a fixedrate mortgage or is it better to
(01:04):
get an adjustable rate mortgage?
I'll dive in more to that injust a second, but before I do
so, want to read the question.
This question comes from John,and John says my wife and I are
looking to purchase a new home.
The mortgage broker isrecommending a seven or 10-year
arm.
Arm, by the way, stands foradjustable rate mortgage.
The interest rate on theseven-year arm is 4.25% and the
(01:25):
interest rate on the 10-year armis 4.5%, while a 30-year fixed
mortgage is 5.25%.
Does the savings of one of theadjustable rate mortgages
justify taking the riskassociated having to refinance
at a future unknown rate?
Does the answer change asinterest rates increase further?
I would hope we would still bein our house at the end of those
arms adjustable rate mortgages.
(01:47):
And that is from John.
Well, john, thank you for thatquestion and, yes, the interest
rates that he's referencing.
This is very clearly a questionthat was submitted several
months ago, so those interestrates are no longer the current
rates that we're hearing today.
But the reality is, by the timeyou're actually listening to
this, interest rates willprobably be a little bit
different, and in six months or12 months or 18 months, interest
rates will be a little bitdifferent.
(02:08):
So, instead of just looking atthose specific rates, what we're
going to do today is walkthrough a framework of how
should you think about this andhow does that framework stay
consistent even as the actualinterest rates will change going
forward?
Now, before we jump in, I alwayslike to highlight the review of
the week.
Thank you, by the way, to allof you who have taken the time
to leave reviews.
This review comes from usernameSlilonic, and Slilonic leaves a
(02:32):
five star review and says Ireally appreciate this podcast
for bringing up so manydifferent client scenarios in
the many ways to think aboutpossible solutions.
I'm an aspiring financialadvisor and I'm very early on in
my career.
This podcast is a greataddition to my daily routine to
help educate me on financialplanning.
I'm currently enrolled to getmy bachelor's degree in CFP
certification and listening tothis podcast has really helped
(02:53):
me to solidify everything I'mlearning.
Thank you, james, for all thethings you talk about and the
excellent way you go aboutexplaining it all.
And that is the end of thereview.
Well, slilonic, thank you verymuch for that review.
I appreciate it.
Best of luck with all thestudying.
It's a wonderful career, so I'mglad this podcast has been
helpful as you've been studyingto enter it.
So let's now jump right intothe content.
When you go to buy a home andthis could be the first time you
(03:15):
buy a home.
It could be because you'rebuying a rental property.
It could be because you'reselling your current home and
relocating somewhere else.
All that is going to be thesame in terms of what we're
talking about today.
When you go to acquire that newproperty, how do you finance it
?
Yes, if you have all cash thisconversation is a little bit
irrelevant but if you're goingto take out some type of a
mortgage, you need to understandwhat those mortgage options are
(03:38):
and you need to understandwhich one might be best suited
for different types ofsituations.
So when you look at mortgages,traditionally, the most common
option is a 30-year fixedmortgage.
You borrow some, some of themoney from the bank.
The bank says here's theinterest that we're going to
charge you for the life of theloan and you have one single
fixed payment for all 30 years,until your mortgage is fully
(03:58):
paid off.
You could have the same thingfor 15-year mortgages or even
20-year mortgages, where you geta rate and what the bank does
is they amortize your payment,saying, based upon this interest
rate and this amount that we'reletting you borrow, here's your
payment that you're going topay us for the end of the term
or until the end of the term,whether it's 15, 20, 30 years.
So those are standard mortgageoptions.
Those are the most common.
(04:18):
But there also are alternativemortgage options.
You could have interest onlymortgages, where you borrow some
of money and you just payinterest on that mortgage until
some balloon payment is due oruntil you've fully paid it down.
You could also have adjustablerate mortgages.
In adjustable rate mortgagesthis is what John is referring
to in his question, and the wayan adjustable rate mortgage
works is they might say James,you can borrow money from us and
(04:42):
we're going to give you oneinterest rate for maybe five
years or seven years or 10 years.
And if you hear someone say I'mgetting a five-one arm or a
10-one arm, what that's sayingis that first number is how long
is the initial interest rategood for, and then one is the
frequency so every year, thatthat interest rate can be
(05:03):
readjusted, and we'll talk aboutthe method by which it does
that in just a bit here.
But when you get an adjustablerate mortgage, what you're doing
it for, the reason you're doingit is you're getting a lower
interest rate than if you wereto go get a 30-year mortgage for
that same amount.
So let's real quickly workthrough how adjustable rate
mortgages work, becauseunderstanding this although many
of you might already know, butunderstanding this is kind of
(05:25):
fundamental to knowing.
Should I go with this optionversus should I go with a more
traditional 30-year fixed typemortgage option?
So here's the quick rundown onhow adjustable rate mortgages
work.
You'll typically see somethinglike five-one arm or seven-one
arm and, as I mentioned before,that first number is how long
the mortgage is fixed for.
So if we use a five-one arm andagain arm stands for adjustable
(05:48):
rate mortgage, that means thatfor the first five years alone
you're going to have a fixedinterest rate.
The second year, so in thefive-one, the one indicates how
many times per year the interestrate can be adjusted after that
initial time of the interestrate being fixed.
So after the first five yearsin this example, then the
interest rate could go up orcould go down, but it goes up or
(06:10):
down based upon some index ratesuch as the London Inner Bank
Offer rate, so LIBOR, forexample.
So what you're going to have isthe mortgage company will say
we're going to adjust your rateat LIBOR plus 3%, for example.
So if LIBOR, so if the LondonInner Bank Offer rate which is a
rate that you're never going tobe able to borrow money at, but
(06:31):
it's kind of like the rate atwhich all other rates or many
other rates are based on ifLIBOR is at 3% and if the margin
on your loan is at 3%, thenyour rate is going to be 6%
after the initial five-year termis up.
If LIBOR goes up to 4%, thenyour rate is 7%.
So it's still that 4% LIBORplus 3% margin.
(06:55):
That's the adjustable part ofthe name.
So the amount of the adjustablerate mortgage can then adjust
each year after the initialfixed time period, and then
there's typically some cap onwhat's the highest this rate
could go to over the life of theloan.
So, for example, maybe the capis 8% or 9% or 10% or whatever.
It is essentially telling youif you get this mortgage, your
(07:18):
rate will never go above 10%,even if LIBOR were to go much
higher in an extreme example.
So, with that basicunderstanding, why would anyone
select an adjustable ratemortgage If you're now at risk
of having your mortgage paymentgo way up, if interest rates go
way up, why on earth wouldanyone elect this?
Hey, everyone, it's me againfor the Disclaimer.
(07:38):
Please be smart about this.
Before doing anything, pleasebe sure to consult with your tax
planner or financial planner.
Nothing in this podcast shouldbe construed as investment, tax,
legal or other financial advice.
It is for informationalpurposes only.
Well, you would choose anadjustable rate mortgage because
for that first five years, orseven years or 10 years,
whatever that first number is inthe five, one or seven, one or
(08:00):
10 one title of the loan theinterest rate is going to be
lower than it otherwise wouldhave been if you had elected a
third year mortgage.
So let's take an example ofwhere rates might be today.
Now, granted, all of theserates are going to depend, in
terms of you getting an actualmortgage, on your credit score,
the loan amount, other factors,where our current interest rates
.
But just for the sake ofexample, let's assume that you
(08:22):
could go out and you're tryingto borrow $500,000 to buy a home
.
Well, you could go get a 30year fixed mortgage and let's
assume the interest rate on thatis 6.75%.
Or you could go get anadjustable rate mortgage and the
interest rate on that is 5.5%.
Well, you can see right off thebat why someone might at least
be intrigued by this adjustablerate mortgage option, that
(08:45):
interest rate is lower than the30 year fixed rate.
Now let's compare the paymentsagain, assuming a $500,000
mortgage, if we're just lookingat the principal and interest
portion of the mortgage, soexcluding property taxes or
insurance, so excluding any ofthe escrow part a 30 year fixed
mortgage at 6.75% on a $500,000loan, your monthly principal and
(09:06):
interest payment would be$3,243 per month.
If you were to get that same$500,000 mortgage but you used a
5.1 arm at 5.5%, well now yourpayment would be $2,839 per
month.
So as you look at these numbers, the principal interest payment
for the 30 year fixed mortgageis 14% higher than the arm was
(09:29):
and the adjustable rate mortgagewas.
So that's a pretty dramaticdifference.
As you're doing your homeshopping and you're trying to
think, where do we want to buynext?
Where's our family going tolive A 14% difference and a
fairly large expense that addsup.
So you look at that adjustablerate mortgage and that's very
appealing to say can I get amortgage rate that saves me a
few hundred dollars each month?
(09:50):
And now here's the thing.
If we knew the interest rateswere only going to get lower
between the time we take outthat loan and the time that loan
is paid off.
The adjustable rate mortgage isthe way to go.
You're going to start out witha lower rate, and that lower
rate is going to continue evenafter the initial fixed rate is
up.
After that 5, 7, 10 years,whatever it might be.
(10:10):
What is the risk, though?
So why wouldn't you moveforward with that?
Well, the risk very clearly putis that interest rates go up.
So let's take a look at that asan example.
Assume you get a 5, 1 arm on a$500,000 loan at the rates we
just looked at.
So you get a 5.5% interest rate, when you otherwise would have
had a 6.75% fixed rate if yougot a 30 year loan.
(10:33):
Well, let's assume that afterfive years is up, interest rates
have gone up and your new rateis 7.25%.
What happens is your mortgagecompany takes your remaining
balance, and you would have paidsome of your mortgage down by
that point.
But they take your remainingbalance and they re-amorotize it
every single year, assumingthat an adjustment was made to
the interest rate.
(10:53):
So, based upon, in this example, still having 25 years left to
pay this off, the mortgagecompany would say what's the new
loan amount?
Well, if it started at $500,000,assuming you made the minimum
payment of $2,839 per month forthe first five years, your
actual balance would be down to$462,300 at the end of those
(11:15):
five years.
They would then take that newbalance, re-amortize it at 7.25%
and now your payment would goup to $3,342 per month.
Now that's an 18% increase, sothat if you're looking at it,
you may not be able to affordthat.
That's the risk.
If your mortgage payment all ofa sudden was almost 20% higher,
would that still fit in thebudget or would you be forced to
(11:39):
move or at least cut someexpenses pretty dramatically?
Now some of you might be sayingwell, james, sure that's an 18%
increase, but that new paymentis only $100 more per month than
the 30-year fixed mortgage.
Otherwise it would have beenBecause, again, the new payment
on the adjustable rate mortgage,after it re-amortizes assuming
a 7.25% rate your new payment is$3,342.
(12:04):
The initial 30-year fixedmortgage was at $3,243 per month
.
So you can look at that and say, oh my gosh, in that case and
now I'm just making up thesenumbers that case it could be
worse, that rate could be higher.
But in that case you might lookat that and say worst case
scenario, or maybe common casescenario is my payments $100 per
month higher than what it wouldhave been with a 30-year fixed
(12:26):
from the beginning.
You might look at that and saythat's not so bad, or you might
look at that and say, well, Icouldn't afford the 30-year
fixed rate to begin with, letalone anything higher than that
rate.
So this is very much where youhave to understand your own cash
flow and your own personalsituation and your own
contingency plans when you havea mortgage rate that's not fixed
(12:47):
and that could go higher, whichwould lead to higher payment
amounts.
So, put very simply, whenyou're asking should I use a
30-year fixed mortgage or shouldI use an adjustable rate
mortgage, you just have to beaware of the risk and that's the
risk.
The risk is interest rates cango up and if interest rates go
up, your payments go up.
So if you're getting and ifyou're reaching for that
(13:07):
adjustable rate mortgage becauseyou say, oh, I just can't
really afford that 30-year fixedrate, but I could afford the
adjustable rate mortgage and I'mjust hoping the interest rates
will be lower in five years orseven years when that initial
term is up, that may be wishfulthinking.
Remember, if we just look backat 2022, many economists at the
beginning of that year assumethat rates would probably go up
(13:29):
by about half a percent in 2022.
Instead, they increase by over4%, one of the most actually the
most dramatic increases in thefederal fund rates that we've
had in the history of theFederal Reserve, in terms of how
fast rates rose.
Now will they keep going up,will they go down?
How long will they stay high?
How long would they maybe staylow?
(13:49):
It's just a guessing game.
No one really knows withcertainty.
So if you're going to go withthat adjustable rate mortgage,
it's not necessarily the worstthing in the world to do so, but
make sure you're well aware ofthe possibility that your rate
might be higher in five or sevenor 10 years than lower.
So don't go into this and getan adjustable rate mortgage if
(14:11):
the only way you could possiblyafford it is if interest rates
happen to be lower in five orseven years than they are today.
If that's the case, not onlyare you setting yourself up for
potential disaster, but, moreimportantly, you're going to
have a huge amount of anxiety ina year, two years, three years,
four years, as you know thatyour ability to maintain your
home, your ability to house yourfamily is contingent upon
(14:34):
something that's completely outof your control.
Now, this is where there'sother factors that you have to
look at.
So here's those other factors.
Let's assume that you'reconsidering mortgage options and
there's a pretty significantspread between an adjustable
rate mortgage and, say, a 30year fixed mortgage, and by
spread I mean the interest ratedifference is pretty significant
.
Well, if you're considering andI'm just going to use a 7-1 arm
(14:56):
in this example if you'reconsidering a 7-1 arm versus a
30 year mortgage and you knowwith certainty you're not going
to be living in that home afterseven years, an adjustable rate
mortgage probably makes a lotmore sense.
You're essentially locking inthat interest rate and you know
that you're not going to be inthe home after that initial
interest rate stops being fixedand begins to adjust based upon
(15:18):
current interest rates.
So if that's the case, anadjustable rate mortgage might
make a lot of sense.
Now I would give you anotherpiece of advice there, that if
you know for certain you're notgoing to be in a home longer
than five or seven years, doesit really make sense to buy that
home to begin with.
If the home is going toappreciate quite a bit then?
Yes, but there's a lot ofstudies and if you actually run
(15:39):
some of the numbers, there's alot of costs and your first few
years of home ownership.
It's everything from closingcosts to the fact that when you
get a mortgage whether it's anadjustable rate mortgage or
fixed the first several years ofpayments are primarily interest
payments, which means you'rereally not building equity with
most of your payment.
There's property taxes.
There's a broker commissionyou're going to pay when you
(16:00):
sell the property.
There's maybe new maintenancecosts when you first move into a
place, when you start to lookat it.
The first few years the chancesof you actually making money if
you know for certain you'regoing to have to sell within,
say, five years aren't actuallythat high.
What you'd have to be dependingupon to make money to buy a
property and quickly sell it isfor the appreciation of property
(16:20):
to increase rapidly.
So are you either doingsomething internally and
renovating the home to make itmore attractive, more valuable,
or do you get to participate inmarket forces driving the price
of that home higher?
If that's not the case, thenyou may not be wanting to buy
that home.
If it's just for a short-termhold anyways.
So that's for a separateepisode.
But point number one is if youknow for certain you won't be in
(16:43):
a home for a long time and ifyou know for certain you are
actually going to buy it.
That's when an adjustable ratemortgage might make more sense.
The second case where anadjustable rate mortgage might
make more sense is you knowyou'll have the means when the
adjustable rate actually startshappening.
So after the fixed rate is upand the rate starts to adjust
after the five-year, seven-yearterm, you may be in a different
(17:05):
financial situation.
I'll give you a perfect exampleof this.
There was actually a couple ofdifferent clients I was talking
to recently, both acquiring newhomes because they're moving to
different parts of the country,and we had the conversation of
how do we finance this?
There's going to be a goodportion as a down payment, but
for the remainder, is itadjustable rate mortgage?
Is it interest only?
Is it a fixed conventionalmortgage?
(17:27):
And as we started to run thenumbers, we weren't just looking
at well where interest rate'sgoing to be, what's the payment
going to be, all those things.
Those are absolutely important.
But we were looking at our bigpicture financial plan and one
of them in these instances hadpretty significant deferred
compensation payments being paidout over the next five to seven
years.
(17:47):
Now why does that matter?
Well, in his situation wedetermined it probably makes
most sense to get an adjustablerate mortgage to lock in a lower
interest rate because, worstcase scenario, if interest rates
do skyrocket, what you've gotsome pretty significant deferred
comp payments come in in.
Those payments can simply beused to pay off the mortgage at
that point.
(18:07):
So that's an example of where Iwould say understand what your
financial situation will looklike at that time.
If you have the income tosupport a higher payment once
interest rate adjusts, or if youhave liquidity or assets to pay
off the mortgage, if youdetermine that's best if the
interest rate adjusts, thenyou're in a much safer position
than if you buy a home and youreally don't have the means to
(18:30):
pay a higher mortgage.
You don't have liquid reservesto pay down the mortgage balance
if needed.
And now you're in a tough spotwhere, if interest rates go up
and you have an adjustable ratemortgage, you're forced to make
some very difficult decisions,one of which might be selling
the home and moving somewhereelse that you could afford.
So make sure you know yoursituation.
Another example of where yoursituation really ties into this
(18:53):
is maybe you have some prettysignificant expenses, maybe
you're paying for children'scollege, maybe you have a
vacation home or rental propertythat the mortgage is going to
be paid off soon, say within thenext five years.
Well, if that's the case andyou've got some pretty
significant expenses falling off, after five years you could
afford for a little bit of anincrease or maybe even a quite
(19:13):
substantial increase worst casescenario to your mortgage
payment after five years, oncethat interest rate adjusts on
your adjustable rate mortgage.
So it's all about understanding, not only comparing the options
between adjustable ratemortgages and your fixed rate
mortgage options, but alsounderstanding your specific
situation when that adjustmenttime comes.
(19:34):
Would you be in a position topotentially have to pay a
mortgage that's 10%, 20%, 30%higher?
If the answer is yes, well,there's less risk in getting
that adjustable rate mortgage.
If the answer is no, now all ofa sudden, there's a lot of risk
in getting that adjustable ratemortgage.
So finally, when you look at allthis, if you knew a certainty
(19:55):
that interest rates are going todrop and that you could
refinance once that adjustmentperiod happens, there's really
no reason to not get theadjustable rate mortgage, but
again, we don't know whatinterest rates are going to do.
Is it likely the interest rateswill drop at some point?
A lot of people certainly sayso, but again, keep in mind that
nobody was forecasting rates togo up like they did in 2022,
(20:16):
where the Federal Reserveincreased rates the fastest it
ever had before.
So when you look at this, itseems like a fairly simple
analysis, and to an extent it is.
When you're just comparingmortgage rate options, you can
run the numbers on a fixedmortgage, you can run the
numbers on an adjustable ratemortgage to see what that
payment looks like, and then youcould run it to see what might
(20:36):
the payments be on an adjustablerate mortgage, based upon what
I like to call worst casescenario.
What's the most?
They could go up after fiveyears or 10 years or 15 years,
based upon the terms of the loan, and then look at your personal
financial situation.
If that worst case scenariowere to happen even if it's
unlikely, you could run thenumbers like that Would you be
in a position to be able to rollwith it, or would you be in a
(20:58):
pretty tight financial situationwhere it would cause you a
great amount of financialdistress and even lead to a
potentially very negativeoutcome.
So that is it for today, john.
I appreciate that question.
For all of you who have leftreviews, I appreciate you doing
so.
If you have not already done so, please take a moment.
Click five stars if this showhas been valuable to you at all,
and also an announcement.
(21:19):
It's been this way for a coupleof weeks now, but we are on
YouTube.
The YouTube channel used to beunder root financial.
Just now, just under my name,james Cannell, c-o-n-o-l-e.
So check out this podcast.
Also check out other greatvideos on our YouTube channel
and again, that channel name isJames Cannell.
So that's it for today.
Thank you, as always, forlistening and I'll see you next
time.
Thank you for listening toanother episode of the Ready for
(21:43):
Retirement podcast.
If you want to see how rootfinancial can help you implement
the techniques I discussed inthis podcast, then go to
rootfinancialpartnerscom andclick start here, where you can
schedule a call to one of ouradvisors.
We work with clients all overthe country and we love the
opportunity to speak with youabout your goals and how we
might be able to help.
And please remember, nothing wediscuss in this podcast is
(22:03):
intended to serve as advice.
You should always consult afinancial, legal or tax
professional who's familiar withyour unique circumstances
before making any financialdecisions.
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