During my days of purchasing homes with mortgages, I had a fondness for adjustable-rate mortgages (ARMs). The appeal lay in securing a lower interest rate compared to a 30-year fixed-rate mortgage. Further, it’s better to align the fixed-rate duration with my planned homeownership tenure.
With the average duration of homeownership being approximately 12 years, opting for a 30-year mortgage term with a higher interest rate is suboptimal. Getting a 30-year fixed rate mortgage is like buying a bus for a family of four.
Despite my rationale, adjustable-rate mortgages often face strong opposition. Indeed, between 90% to 95% of new or refinanced mortgages fall under the 30-year fixed-rate category. It is logical to be against something you don’t understand or have.
Despite experiencing the largest and swiftest Federal Reserve rate hike cycle in history, there’s no rush to pay off your adjustable-rate mortgage before it resets. Allow me to illustrate using my own ARM as a case study. I’ve taken out or refinanced a dozen ARMs int he past.
No Hurry To Pay Off Your Adjustable Rate Mortgage
Most ARM holders will turn out fine once their introductory rate period is over. Here are the five reasons why:
1) You will pay down mortgage principal during your ARM’s fixed-rate period
Back in 2014, I purchased a fixer-upper in Golden Gate Heights for $1,240,000, putting down 20%. I opted for a 5/1 ARM with a 2.5% rate, resulting in a $992,000 mortgage. Though I could have secured a 30-year fixed-rate mortgage at 3.375%, I chose not to pay a higher interest rate unnecessarily.
Then, on October 4, 2019, I refinanced the remaining $700,711 mortgage to a new 7/1 ARM at a rate of 2.625%. Once again, I had the option to refinance to a 30-year fixed-rate mortgage at 3.5%, but I stuck with the lower rate. Additionally, while I could have selected a shorter ARM duration for a reduced rate, I found that seven years struck a balance. This was a “no-cost refinance,” which is what I prefer.
Throughout the years, I made regular mortgage payments and occasionally applied extra funds towards the principal when I had surplus cash. Through this method, I managed to reduce the principal by $291,289 over 5 years, amounting to a 29.3% decrease from the original mortgage balance.
This process of paying down the mortgage didn’t impose any liquidity constraints or cause stress. I simply adhered to my FS-DAIR framework. It determines how much cash flow to allocate towards investments or debt repayment as interest rates changed.
2) Your mortgage pay down momentum will continue
Since refinancing $700,711 on October 4, 2019, I’ve managed to reduce the principal loan balance by an additional $284,711, bringing the current mortgage balance down to $416,000 today. Throughout this nearly five-year period, I continued to experience zero liquidity constraints or stress while paying down the principal.
There are several factors contributing to this steady reduction in the mortgage balance. Firstly, a lower mortgage rate increases the proportion of the monthly payment allocated to paying down the loan, resulting in more principal being paid off over time. Secondly, despite the drop in my monthly mortgage payment following the refinance, I maintained it at the same level to pay down extra principal. Finally, whenever I had extra cash available, I continued to make additional payments towards the principal.
However, the frequency and amounts of these extra principal payments decreased in 2020 when COVID struck and interest rates plummeted. It was more prudent to retain cash during the uncertainty and then invest in the stock market after prices fell. As inflation surged, I found myself with a significantly negative real interest rate mortgage.
3) Elevated inflation rates will likely recede by the time your ARM resets
Inflation and mortgage rates experienced a sharp rise in 2020 and 2021, reaching a peak in 2022 before gradually declining. The Consumer Price Index (CPI) peaked at 9.1% in mid-2022 and now stands at around 3.3% in mid-2024. Elevated inflation has thus far proved to be transitory. It would be surprising if CPI were still above 3.5% by mid-2025.
Recent economic indicators suggest a slowdown in inflation, with May jobless claims exceeding expectations and May Producer Price Index (PPI) coming in lower than expected. Rate cuts are an inevitability.
Many ARMs have durations of five or seven years. For instance, if you secured a 5/1 ARM in March 2020 when the 10-year Treasury bond hit about 0.61%, your 5/1 ARM rate would be closer to 1.75%. With such a low payment, you would have been able to save even more cash flow during this period.
As your 5/1 ARM resets in March 2025,…
Read More: No Rush To Pay Off Your Adjustable-Rate Mortgage Before Reset