commented, "My guy and I are starting to homebuying education journey now. I am afraid of ARMs, but pushy salespeople make it sound like they're brilliant. How do you know if an ARM is right for you?"
This is a really long response and doesn't get to the point till the end. I'm still working on structure to my writing so bear with me. I promise there is good stuff in here.
First thing, read up about mortgage products. I highly recommend the Peter Miller book, The Common Sense Mortgage
. I learned a lot from his advice and explanations about homebuying and different financing options. He is methodical in reviewing a wide variety of products, including long-term (40+ years) mortgages. A lot of the reasons why I don't like the 50-year mortgage product comes directly from his explanations about 40-year mortgages. (The same reason applies, you are paying exorbitant amounts in interest on a longer term mortgage. The longer the term, the more interest.)
I didn't know that hybrid 7/1 and 10/1 ARMs existed until I read this book. I wasn't savvy enough to ask my mortgage lender about them. Initially, I asked the banker about a "3-year Interest-Only" loan. I got a pre-approval and started looking at condos. Somewhere in there, I re-read the Miller book in great detail and made a note of what kind of mortgages sounded good to me. My banker was a little shocked when I asked about these longer term ARMs. She advised that they would be Principal and Interest since they don't carry them as Interest-Only.
There are 3 main things I looked for in a mortgage:
1. Am I buying more than I can afford/want to own?
2. Is the mortgage payment affordable in the monthly budget?
3. Fix the interest rate for as long as you can.My number one piece of advice: Don't buy more home than you can afford.
I cannot stress that enough. I know folks who were eating ramen noodles daily their first year of homeownership. It's not good to be house poor after settlement. Retain some of your downpayment money for random little house repairs. Little stuff will crop up that you didn't quite expect to have to fix and those will take a bite.
Think about your space needs. Do you really need 1400 sq. ft. apartment if you're a single person? I am making do with 500 sq. ft. just fine. I could have gone for a 1 or 2 bedroom place, but I would probably be living with a loathsome roommate collecting rent so I can afford the mortgage, not a fun situation to be in.Second piece of advice: Know your limits on what you're willing to do for maintenance.
I live in a condo so I don't have to take care of a lawn. Mowing and weeding is not how I want to spend my weekends. Gardening I don't mind. I love flowers and vegetables, but I hate chores so having a lawn isn't for me. I know I'll probably pay someone to maintain my lawn. That is, if I'm not too cheap to relent and do it myself.
Next, my mortgage payment was not very affordable when I first purchased my home. That wasn't entirely the fault of my lender, but more like my confusion about what I was paying and having a job that didn't pay very well. Either way, I also didn't understand that the state of VA reassessed property taxes EVERY SINGLE YEAR. I grew up where it was done every 3, so I was pretty darned surprised that my payments were going up by $50/month after the first year. Check out what your jurisdiction does for assessments and factor that into your escrow amount.
In my first year of homeownership, there were times that my second paycheck wasn't just gravy for me, but essential for escrow. In the end, I resolved the issue by getting a better paying job, but try to keep your payment to the lower end of the 28%-36% of monthly income ratio range when calculating mortgage affordability. Just to be safe, add on an extra $100 to the monthly payment amount to allow for future fluctuations in payments, especially if you are going with an ARM. In fact, realize that with an ARM, your payments can change by hundreds of dollars. Try to see what your payments will be like with different rates and see if you can absorb those changes into your monthly budget. Read your loan papers extremely closely. Mine had limitation clauses on how much the rate could change in a year which would be a blessing if rates had risen extremely fast. (i.e. if rates go up 4% in a year, your loan might have a limitation clause saying it will only go up by 2% until the next adjustment.)
Finally, back to the original question, 'How do you know if an ARM is right for you?' It's the same question as, 'Why did I choose a 10/1 ARM over 30-year fixed or the originally quoted 3/1 I/O ARM?'
I looked at the current interest rates and the trends for the future. I figured that I was looking at some of the lowest rates I would ever see in my lifetime. I know the rates back in 2003-2004 were definitely some of the lowest that my parents had ever seen, so chances are what goes down must come up. These rates were quite possibly the lowest I would ever see as well.
More than any other criterion, I went for as long a term fixed period as I could stand. I didn't go with the 30-year fixed mortgage because the rates at the time were higher than for the 7/1 and 10/1 ARMs. I didn't go with the original 3/1 I/O ARM because frankly I was really scared at how fast interest rates could rise in a year. (The FOMC meets every 6 weeks. That's potentially a lot of quarter percent rate hikes in a year.) Plus I wanted to build equity in my place and I felt that I was not disciplined enough to make additional payments on top of the interest only mortgage. The bank I chose only offers 7/1 & 10/1 ARMs as principal and interest mortgages. They don't offer them as interest-only at all.
A lot of of financial advisors will determine if you should get an ARM by asking how long do you think you'll stay in the house. In my case, I tried not to think about that at all. I know that I could stay in this apartment for 3 years, move out and rent it. I know I could stay in it for 10. I know I could sell it in 5 as well. There really wasn't a clear answer to this question since I'm young, single and still geographically mobile. (The latter I think directly applies to Debt Hater's situation since she's not originally from Tennessee.) (Final point, I don't know anyone who lives in a studio for 30 years, so the 30-fixed option was out at the beginning.)
Keep in mind, I love fixed payments. I hate the annual reassessment. I'll do anything to avoid it, including paying extra into escrow so my payments stay the same. I know a lot of PFBloggers probably thing that socking away extra money into escrow is a bad idea due to foregone interest, but it isn't if you are relying on a fixed amount monthly for your budget.
In the end, it's a risk tolerance thing, while you gamble on interest rates. And it's an affordability thing and what you are willing to pay each month.
I know I digressed several times in this post, but I genuinely care about educating folks about the many types of mortgages out there. Whatever is widely quoted by fast-talking, slick brokers isn't the only mortgage out there. Do your research. Your analysis might find more appealing mortgages than what your broker shows you.