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Adjustable Rate Mortgage: What's the Worst Case Scenario

Contributed by mm | February 10, 2014 4:15 AM PST

Back in January when I shared my experience choosing an adjustable rate mortgage (ARM) over a more traditional fixed rate mortgage (FRM), I received the following comment from Adam:

I would be interested in understanding more about why you have better options at the end of the ARM. I have thought about getting an ARM, but the potential larger payments in 5/7/10 years seems like a potential albatross. If rates go up, you can end up paying a lot more, and if they're already increased, I don't see how refinancing is going to help you. Perhaps you could discuss or link to an article that helped your analysis.

Certainly our well-defined timeline of living in this house for slightly over 7 years until we send our son to college plays a huge role and almost single-handedly make ARM a much better choice than a 30-year FRM at an interest rate 1.25% higher -- the interest rate difference means over $70K lower interest payment thru the ARM route in the first seven years on the $852K mortgage we ultimately got -- but it is worthwhile to be more analytical on explaining how we will prepare for the worst case scenario.

Let's start with the key terms of our existing mortgage:

- Initial Principal Balance: $852,000
- Start date: 2/1/2013
- Initial Interest Rate: 1.875% until 2/1/2020
- Initial Monthly Principal + Interest Payment: $3,096.17
- Interest Adjustment Date: every year starting 2/1/2020
- Index and Margin: One-Year LIBOR plus 2.25%
- Annual Interest Rate Change Cap: 2%
- Lifetime Interest Rate Change Cap: 5%
- Discount Points: 0.75%

We should also define what's the absolute worst case scenario that we need to prepare for by the time our initial favorable interest rate ends in 7 years. To me the doomsday in 2020 for a homeowner will be like:

- Interest rate index in our adjustment rate mortgage resets to a high rate that greatly increases our monthly payment.
- Our home's market value drops so much that we have negative equity in the house if we choose to sell it.
- Refinancing is impossible due to the confluence of higher interest rate and negative equity.

First, let's calculate how our monthly payment will change in the worst case scenario. By the first rate reset of 2/1/2020, our principal will drop to $693,709.72, thanks to the low rate in the first seven years that enables rapid principal repayment. The maximum rate in our 8th year will be 3.875%, which means a 23% monthly payment increase to $3,801.50 by amortizing our remaining principal over the remaining 23 years of the mortgage. 23% is big but the absolute dollar difference is only $700, not something that will keep us awake in the middle of the night.

And what if rate keeps rising? Our rate will be reset to the contractual maximum of 6.875% by 2/1/2022, and our monthly payment will further increase to $4,949.53, almost $2,000 or 60% higher than our current monthly payment. It may be an alarm sign, but still, the $24,000 a year additional payment, mostly as interest, is fully deductible and the real ding is more $17,000-ish at a margin tax rate of 28%.

More importantly, in 7 years, current conservative forecast puts our net worth north of $3M, and this financial muscle will give us many choices when our mortgage bill spikes.

The choices will be between whether to reinvest our net worth for better returns, or to pay off the mortgage should no such reinvestment opportunities exist. Should we enter a period of super high lending rate like 12-16% for a 30-year fixed rate mortgage in the early 1980s, we might be even better off by parking our growing net worth in savings account earning double-digit returns while paying our mortgage at the capped 6.875% interest rate.

After all, we could have bought our house in cash but we chose not to, and we can pay off our mortgage any day today but we choose to keep paying the minimal so we can take full advantage of the ultra-low interest rate. Yes, there are risks but we are well covered for the worst case scenario.

P.S. The real danger, however, lies in sustaining our earnings ability, for physical or intellectual reasons. To that end, our over $5M combined insurance coverage between life insurance and accidental death and dismemberment (AD&D) insurance truly allows us to have sound sleep every night.

This Post Has Received 40 Comments. Share Your Opinions Too.

Adam Commented on February 10, 2014

Thanks, this is very interesting. I had been working with Citi and looking at their ARMs, which appear to be different from Wells Fargo. Citi has 5/2/5 ARMs, meaning the FIRST interest rate adjustment can be up to 5%, any subsequent adjustments (each year) can be no more than 2%, and the lifetime cap on the interest rate adjustment is 5%. So I was looking at the potential of going from 2.25% to 7.25% at year 8, which is harder to stomach than a somewhat gradual 1.875% to 3.875% jump you mentioned. We still have student loans and lack the equity backup you have, so I'm leaning towards fixed for comfort.

Your P.S. gave fodder for another post: how did you decide on $5M for insurance? Your premiums must be huge - don't you feel like your savings are sufficient?

MM Commented on February 10, 2014

Adam, you are right that it can make another good post (or two). Here is the short version: our financials are healthy but if I will be hit by a bus tomorrow, our savings won't be sufficient for my wife and son to live a comfortable life. That's what we want to cover. Between $2M term life for me, $1M term life for my wife and $2M AD&D for me thru employment, we are paying about $2000 a year for the peace of mind.

Also on the liability side we also keep $2M umbrella insurance for auto and home.

Thanks again for commenting!

Bobson Commented on February 10, 2014

MM, have you thought about long term disability insurance? I'm told you're far more likely to become disabled at some point than die. Also, unlike in death, your family's expenses may stay the same or even rise (medical bills) should you become disabled, making the loss of income that much more difficult.

MM Commented on February 10, 2014

Bobson, yes that's a good call out. Yes, I have the long-term disability insurance from employer as well covering 60% of income. That's truly important.

Thank you for commenting!

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