Episode Transcript
[00:00:00] Speaker A: Hey, guys, I hope you've had a good week so far. Before, uh, we hop into this week's episode, I wanted to tell you about a, uh, webinar that's going to be hosted on the escape student loan debt platform. I always share that escape student loan debt, for compliance reasons, is a separate entity from new money, new problems. But the topics sometime align. And on that escape student loan debt platform, we're going to be doing a webinar on the current state of student loans. So we're going to be talking about federal student loans, private student loans, all the stuff that's been going on that we've covered in brief detail over the past past several months on this podcast. So we're going to put a link to that webinar in the show notes. If you'd like to register, it's, uh, going to be in a couple weeks. You'll be able to see the date, details, and how you can be in the room. Now, let's get to this week's episode where we talk about an often maligned, rarely understood form of mortgage called an adjustable rate mortgage or an arm loan.
[00:00:53] Speaker B: Let's get some money from new money new problems. It's the new Money New Problems podcast, a show for successful professionals searching for the tools they need to navigate financial opportunities and obstacles they've never seen.
Negotiating compensation, purchasing your first investment property, helping your family with money, the highs and lows of entrepreneurship. New money brings new problems that require new solutions. Join us as we work through them together.
I'm Brenton Harrison, and this is the New Money New Problems podcast.
[00:01:31] Speaker A: Hello. My name is Brinson Harrison of New Money new problems, and your host for the New Money New Problems podcast. I hope you've enjoyed over the course of the last month, uh, our series on credit and home buying, because oftentimes those two topics go hand in hand. You have to have good credit to get the best home loan, and so on and so forth. In this episode, I wanted to bring back something that is often mentioned in periods where there's volatility in the mortgage interest rate arena, and that is an arm loan or an adjustable rate mortgage. And if you're old enough to recall some of the financial terminology that was being thrown around during the financial crisis, you will recall that arm loans during that era were some of the worst things that you could possibly have. And because of the structure of these loans, there became a period in time where they essentially blew up in their face. People couldn't afford the payments and were left out in the cold. Now, there's been a number of modifications, both in terms of mortgage underwriting requirements, but also the structure of arm loans, in particular over the past several years. And while there is still significant risk that comes with having an arm loan, there are two factors at play when I'm thinking about doing this episode. The first is, while there is risk, it does not mean that there are no scenarios when it would be an appropriate, uh, uh, mortgage to have. So I wanted to make sure that you understood, in my opinion, what some of those scenarios may be. But second, even if you don't choose to do an arm loan, you know, our philosophy here is that we want to cover and make you financially literate in areas where you may have some confusion as it stands now. So in this episode, we're going to break down how arm loans are structured. And in the second half of this episode, we are going to talk about some instances where an arm loan may be an appropriate type or at least an appropriate option to consider for your home or your investment property. The first thing you need to know about an adjustable rate mortgage is obviously the interest rate on the mortgage can adjust, but it does not adjust immediately. When you see people talk about arm loans, they may say, I have a set seven one arm or a five one arm or a six six arm. And you'll see that characterized as, for example, seven one. And the first number in that sequence, if we have for example, a seven one loan, is the number of years that your interest rate will be fixed on your home loan. And because arm loans are not fixed for the entirety of a period, as compared to something like a 15 year mortgage or a 30 year mortgage, you often find that the interest rates on Arm loans are lower than what you find for conventional mortgages. As an example, if you're looking on screen and you type in current mortgage rates on Google, you can see that it pulls up an average 30 year fixed rate for someone with a 700 credit score of 7.508%. But if we go to current adjustable rate mortgages and we look at, for example, a seven one arm, it shows an interest rate of 6.53%. It is not always the case, but you will often find that the more popular structures of, uh, arm loans have an interest rate that is lower than conventional rate mortgages, which is what makes them attractive on the front end. Now, the second half of that slash, in this example seven one, is how frequently they can change your interest rate after the initial fixed period. So if the interest rate is fixed for the first seven years, after those seven years have passed, your lender can adjust the rate on your mortgage as frequently as once per year. Going back to the screen. As an example, you can see a three one arm, which means the rate is fixed for three years and can change as frequently as annually thereafter. But if you were to see something that said a seven six arm, it doesn't mean your lender can only change that rate every six years. That six would represent six months, so fixed for the first seven years and can adjust semiannually thereafter. Now, in terms of how they set both the initial interest rate and also how they determine the changes on your loan, that's determined by two different factors, the rate of an index they use as a reference point, and also the margin above that rate that they use to determine what you actually pay on your arm. If you're looking on screen, and we'll share this in our show notes, you're looking at an example of a quote for an adjustable rate mortgage. And you can see that the index plus margin for this loan is the CoFi index plus 2.5%. CoFi is the cost of funds index. It's one of the indices that many lenders use to set the rates for adjustable rate mortgages. So in this example, when you see an initial interest rate for the fixed period of 7%, that implies to me that at the time they set this interest rate, the cost of funds index was at 4.5%. They added the margin of 2.5% to come to the initial interest rate of 7%, which is what they're going to charge you for the initial fixed rate period of the loan. And when you have an arm loan, we talked about the first set of numbers that are expressed as x x. So in our example that we talked about earlier, seven one. But there's also another set of variables that you can see as x x slash x. It would give you three numbers. So in our example, if you're looking at this quote, we have a seven one arm loan. And I'm going to show you how you can use this quote to understand that this would be expressed as a three two five arm loan. The first number in that sequence of three two five is 3%. And what that means is that after the initial fixed rate of the home loan, 3% is the maximum increase or maximum decrease that you can see in the rate that you were paying. So in the quote that you see on screen, again, we'll share this. In the show notes, you see an initial interest rate for the fixed period of 7%. And that first rate change would come after six years. So in this example, if three was the first number in the sequence, then for our current 7% mortgage, when that fixed rate period expires, the maximum increase that you could see in the interest rate would be up to 10%, 7% plus 3%, and the maximum decrease in interest rates would be down to 4% 7% -3% so we have a sequence that says three two five. The second number in the sequence, three two, represents the maximum change that you can see after the first adjustment. So, in our quote, this mortgage can only be adjusted once every year. And while the first adjustment could be as high or low as a 3% increase or decrease, after that it's limited to a 2% increase or decrease. It doesn't mean it's going to be that much. It's saying that's the maximum that it could be on either side of the equation. So we have the three, we have the two, and now the five. The five represents the maximum increase or decrease in the loan rate over the entirety of the repayment period. So if we started this fixed rate period at a 7% interest rate, that means, even though that's a very wide range, that throughout the course of the repayment of this loan, which could be for 30 years, the highest the interest rate could go is 5% above the initial rate, which would be 12%. But the lowest it could go is 5% below the initial rate, which would be 2%. So three two five tells you the rest of what you need to know about this loan. And we can now look at this quote and see how those numbers are reflected. For the index plus margin, we have a COFI plus 2.5% that at the time meant m we paid an initial interest rate of 7%. The minimum interest rate on this loan is going to be 2%. The maximum is going to be 12%. The rate is fixed for the first six years. After that 6th year, it can be changed as frequently as once per year. The maximum adjustment of the first adjustment can be 3%, and thereafter the maximum adjustment is limited to 2%. So now you're equipped. When, if you're looking for a home loan, your lender says, hey, instead of this 30 year or 15 year mortgage, what about a seven one arm or a yemenite five six arm? But you're probably listening to this and saying, why would I even deal with this? Why wouldn't I just pay for the 30 year loan or a 15 year loan? Because I don't want that level of uncertainty. And what if I sign up for an arm, and the same thing that happens to me as is what's happening to people all around the country right now, which is they signed up for an arm when interest rates were fairly low but were starting to creep up. And the hope was that by the time that initial interest rate period expired, that mortgage rates would have decreased. But in fact, they have actually increased. And because of that interest rate increase, you have tens of thousands of people across the country who are about to watch their mortgage rate adjust upwards for the first time, and it could have a monumental impact on their ability to actually stay in that home. If you're looking on screen, you're seeing an article that will share in the show notes from CNN saying thousands of homeowners are about to get slammed with higher monthly payments. And in this article, they share that 1.7 million people have bought homes with adjustable rate mortgages since 2019. Many of those buyers who bought five year arms, one of the more popular offerings that I'm quoting, will graduate into significantly higher monthly payments this year. So these are people who, when rates were low, took a gamble on an arm, and in 2024, they're having to pay the piper and facing interest rates that in some cases could have tripled above and beyond what they have on the initial rate period. So while this may seem incredibly frightening, after the break, I'm going to tell you some scenarios where, even in spite of this, an arm loan may be right to consider for your home loan.
[00:11:35] Speaker C: This is the new Money New Problems podcast, a show for successful professionals searching for the tools they need to navigate financial opportunities and obstacles they've never seen. We'll be right back.
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[00:12:43] Speaker A: All right, you all. Uh, if you listen to this podcast, you know that I don't mind setting myself up to have the pressure of backing up a statement that might seem controversial. So how am I going to prove that? There are some scenarios where an arm should at least not be just thrown away as a potential option. Let's go through them. The first is if you have an investment property that you don't plan to keep for the long term, there, uh, are people out there who are buy and hold investors when it comes to real estate, and they're putting themselves in situations where they have the intention of keeping that home for 20 or 30 years. Even if they sell it down the line, at least when they bought it, they bought it with the intention of it being a long term property. But there are also people out there who are more interested in keeping it, getting some profit out of it, and flipping it, if the value of that home should increase. So if you're buying a home in a very well to do area, or an area that you think will become well to do, maybe you plan to put some renovations into that property. It may be something where you are looking at a short term play, where you may be having tenants in that property to try to cut down on your upfront cost, but the intention is to sell the property definitely within that five to seven year window that you typically see for most arms. Then it might be a situation where having that potentially lower interest rate on the arm could be appealing as compared to a 15 year mortgage or a 30 year mortgage. It's also important to understand with investment property, and we haven't touched on this to this point in the podcast, but for most lenders, if it's not something that you're living in, you're required to put a 20% down payment. It's not like primary homes, as we've talked about, where you have that flexibility, many lenders require the 20%, and to get the best rates on investment properties, they might require 25% of the value of that home as a down payment. So if you're already giving up significant assets to it, and you have an option of potentially having a lower payment, it's something that you could use as a strategy to lower your cost until you wait for that property to sell. Even with your primary home, there are some instances where you may be in a situation where you're buying a property knowing that that's not something that you plan to be in for a long time. Or maybe you're just a person who is comfortable with the risk that five or seven years down the line, if interest rates have gone up significantly, you might have to move. You would be a person who could consider an arm loan for their property. The next scenario is you actually pay attention to what's going on in the market to have some idea of where interest rates are headed. Now, there's no guarantee when judging when or how high or low interest rates will rise or fall. But there is the ability to do things like reading the Fed report, like keeping up with their ideas of what's going on in the economy, to know whether they even have the intention of increasing or decreasing interest rates. For example, if you were buying an arm loan in 2020, I would be telling you, look, it is highly unlikely that we will ever have interest rates lower than this. So five to seven years from now, if I'm a betting man, I would tell you that interest rates will have increased because this 2.5% or 3% or 4% mortgage that you're currently paying on a 30 year loan, if you were to get a fixed rate, is not something that's going to happen again unless there's been another cataclysmic event. So if you're now sitting and you're looking at an arm, and the interest rate is 6.5% compared to a conventional or fixed loan, that's at 8%, and you're keeping up with the Fed, and they're telling you that over the course of the next few periods, they plan to lower the interest rates on that home loan, then you may be better informed to make a calculated, yet risky decision of saying, you know what? Based on the trends that I'm seeing in the economy, I believe that after the end of this period, or even during this initial period, I will have the ability to refinance to a similar rate. A rate that's not significantly higher than my current fixed rate, or ideally, a rate that's actually lower than your current fixed rate. Next, you're a person who has other financial goals that take priority over a higher loan payment. We've talked about ad nauseam, the fact that nothing that you do financially happens in a vacuum. One decision impacts other decisions. But the last thing you have to have for an arm to be something you could consider is really a tough stomach. Right? There's a peace of mind element to this that you have to confront. There are people out there who can sleep very well at night with a significant amount of financial risk on their shoulders. And there are people out there who cannot sleep for even 20 minutes if they owe somebody $10, or if they feel like something like an arm loan might explode in their face seven years from now. So you have to know yourself. And if you're the type of person who's listening to this, saying that would freak me out to no end, then an arm wouldn't be right for you. But if you're understanding the risks, the pros and cons, and you're comfortable with the downside of that equation, then it's something that might be an opportunity for you and your family. And I've had this conversation with friends who have looked into an arm loan, and I've told them, as long as you're comfortable with the idea that five or seven years from now, you may have to leave that property, if things don't work out, then it's something you should consider. And if all those things are working into play, I can lay out the scenario of someone who might be a person for whom an arm loan is the perfect fit for their scenario. Let's say that you're a PhD professor and you are teaching at a university that's kind of out in the sticks. And the primary reason that you're working there is because you're trying to build up your career to where you can be an associate professor or a lead professor. And this is the place that you have. You don't really love that place, but it's just kind of a means to an end to build your resume. And maybe you're making 100, $125,000 a year, and your student loan payment is seven, $800 a month, a significant amount. Well, if you've been working in these education systems for seven or eight years and that institution is eligible for public service loan forgiveness, then you could be in a situation where in two or three years, that significant payment towards your student loans will go away. And two or three years from now, it's unlikely that you would still be in that same area, because your goal is to go on to the next institution where you can be the next level up in the ladder. Well, if you're trying to find a home m and juggle maybe some credit card debt, some student loan debt, some other financial responsibilities, and you're in a place that you know you are unlikely to be in. Or if you are still there, you're likely there because you've got a significant pay increase, then it could be the perfect scenario where an arm loan would be amongst the options that you consider. So when you see these things online that you don't understand, but someone is telling you that you shouldn't do them, I want you to first educate yourself about the issue and then apply it to your circumstance. And if it's truly not the right thing for you, then ignore it, go on to the next thing. But there are reasons that these tools exist, and when you have an understanding of your entire portfolio, there are scenarios and instances where an arm loan could be appropriate for you. I'll see you next week.
[00:19:44] Speaker B: From new money new problems this was the new Money New Problems podcast, a show for successful professionals searching for the tools they need to navigate financial opportunities and options they've never seen.
