Posted on Jul 14, 2021
Mongoose versus cobra. Coyote versus Roadrunner. Pirate versus ninja? And finally, “Fixed-rate mortgage vs. variable-rate mortgage”. Yes, we are talking about the greatest rivalries of all time.
So what's better, the boring old fixed-rate mortgage or the more provocative and often controversial adjustable rate mortgage (ARM)?
During the real estate boom in the early 2000s, homeowners often chose adjustable rate mortgages to qualify for a home that they probably couldn't afford with a traditional fixed-rate mortgage.
Back then, you could qualify a borrower at the ARM's lower starting rate, although the loan would eventually adjust much higher.
Even if they could afford a fixed rate loan, homeowners were happy to take the lowest interest rate usually associated with the ARM.
But times have changed and variable rate mortgages have gone out of style with fixed rate mortgages near record lows.
In fact, fixed-rate mortgages make up more than 90% of the buy-money mortgages and refinancing loans in use today.
Sure, fixed-rate mortgages are definitely more popular, but that doesn't mean they're better or always the right choice.
It's just a matter of preference for most. And as homes become less affordable, ARMs will become even more popular.
Fixed rate mortgages like the 30 year mortgage are the standard option
- Most homeowners choose fixed-rate mortgages when buying a home or refinancing an existing loan
- We're talking about 90% or more of all home loans being 30-year or 15-year fixed-rate mortgages
- ARMs were very popular prior to the mortgage crisis because of their relative affordability
- But now you have less than 5% market share (that could change if home prices keep rising)
When taking out a mortgage, most people choose a fixed rate mortgage, which makes it the standard option.
The most popular of the fixed-rate mortgages is the 30-year fixed-rate mortgage because the payment is locked for the life of the loan and the long payback period keeps monthly payments low.
The 15-year fixed-rate mortgage is also very popular, but since the entire remaining amount has to be paid off in half the time, the monthly payments are significantly higher. That means fewer borrowers are willing or can choose for reasons of affordability.
Typically, a homeowner starts with a 30 year term and then when it comes to refinancing, sticking to a 15 year term to stay on track and avoid resetting the clock.
There are also adjustable rate mortgages that most borrowers avoid unless they are an extremely savvy type of investor, ultra rich, or instructed to do so by their mortgage broker or loan officer.
I say savvy because, despite the associated risk of a higher interest rate in the future, some people will take a risk on the initial interest rate rebate on ARMs.
So, you need to know what to do when choosing an ARM and, most importantly, have the ability to absorb future interest rate adjustments.
As mentioned earlier, there were also those borrowers who had to take out an adjustable rate mortgage in order to qualify due to the lower interest rate.
This was a routine practice prior to the mortgage crisis, with the ARM option usually being launched by the real estate agent, broker, or loan officer, whether or not it was in the best interests of the borrower.
This is not so common these days as it is not necessarily easier to qualify for an ARM as you will often have to qualify at the fully indexed price.
What kind of ARM are we talking about?
- Today's ARMs are usually hybrids with a fixed and adjustable period
- You have a fixed interest rate at the beginning of the loan period for X years
- This is followed by a variable interest term for the remainder of the loan term
- That makes them a bit safer, but not as cheap as they would otherwise be
The big question in the debate about choosing between Fixed Rate and ARM is what type of adjustable rate mortgage loan are we dealing with?
Nowadays it is quite common to take out an ARM with an initial fixed income period, e.g. B. a 5/1 ARM or a 7/1 ARM.
The above examples are fixed for the first five and seven years respectively before being adjusted annually for the remainder of the term. For this reason, they are called hybrid ARMs.
There is even an option that is pegged for 10 years before the first adjustment, which makes it relatively low-risk.
This means that you have some breathing space before the interest rate adjusts up or down. That's right, your mortgage rate can go up or down if it is an ARM.
And all of these ARMs are written off over a 30 year period, which means they will take 30 years to pay off, assuming you hold them to maturity (which most borrowers don't).
So they're the same in length as a fixed-rate mortgage, and if you only hold them for five or seven years, they'll behave no differently in terms of the amount of amortization and interest.
In fact, you'd likely be paying off more of your principal balance and paying less interest due to the lower interest rate on the ARM.
The main difference is that the 30 year fix is, um, fixed while the ARMs are, you guessed it, adjustable. By adjustable, I mean that your mortgage rate can go up, down, or sideways.
Obviously, this is at serious risk if mortgage rates skyrocket during the short few years that you are holding the loan.
ARMs can go up and down
- ARMs can adjust up or down over time depending on the associated mortgage index
- In this respect, they do not necessarily have to be refinanced
- If, on the other hand, mortgage rates drop significantly after receiving your loan
- You may need to refinance your fixed-rate mortgage to take advantage of lower market rates
While it is possible that mortgage rates could fall in the future, they are still near record lows and will most likely rise in the next few years.
So an ARM you get today will likely reset higher the first time it is adjusted, which means your monthly mortgage payment will go up.
If you can't handle that hypothetical higher mortgage payment, you might want to stick with the 30 year fix, even if it's a little higher today.
But do you stay at home for 5-7 years or are you moving? And will you refinance before then?
If there is a chance you will do both, an ARM might make more sense than a fixed-rate mortgage.
For example, if you are buying your first home but plan to move or upgrade to a better home when you are raising a family, a short-term adjustable rate mortgage may be your best option.
And the money saved over those couple of years can be used to pay a down payment on the next house. Additionally, the lower interest rate makes it more affordable during the months it is held.
Meanwhile, it has not been uncommon lately for homeowners to choose a 30-year fix and then refinance into another 30-year fix shortly after an improvement in interest rates.
Right now, the ARM-linked mortgage indices are so low that your first interest rate adjustment could result in a lower interest rate, assuming there is no lower bound on the interest rate.
For example, many of these ARMs are linked to LIBOR, which is currently around 0.25%. If the margin is 2.25, your mortgage rate would drop to around 2.50% assuming the upper / lower bounds allowed for it.
However, this low interest rate environment isn't going to last forever, so someone who opts for this type of ARM is likely to suffer in the long run.
Most will likely need to refinance or sell themselves before this happens. For this reason, short-term ARMs are usually reserved for the very wealthy, who have the option to refinance or pay off the loan at any time.
If you decide to buy an ARM and don't have the option to pay it off or refinance it, you could be stuck with a rising payment, which could put your mortgage (and property) at risk.
Also note that both fixed-rate mortgages and ARMs require active participation. Just because your loan has a fixed interest rate doesn't mean you don't need to keep track of interest rates.
When rates go down, you can lose if you don't refinance your fixed-rate mortgage. So it's not what it seems.
Tip: Never choose an adjustable rate mortgage just to qualify for a loan. If you can't qualify for a fixed-rate mortgage loan, consider waiting and renting or buying a cheaper property.
Does an ARM's initial discount justify the risk?
- Make sure the ARM discount is worth the risk of a potentially higher price later
- Also, consider how long you will be keeping your home loan and the property
- You may not hold it long enough to ever worry about a rate reset
- If so, it could be a much better deal than the more expensive fixed-term loan that you are not going to take full advantage of
Make sure you get a good discount on the ARM in return for the uncertainty and risk that it will increase in the future.
Currently, the 30-year fixed-rate mortgage rates hover around 3% while the 5/1 ARM is around 2.50% depending on the lender.
That spread isn't huge right now, which means ARMs aren't all that cheap.
If it is a short-term ARM, e.g. If you have a 1-month or 1-year ARM, it is better to save a considerable amount of money early on.
With a $ 250,000 mortgage, the ARM would save you about $ 66 per month, or nearly $ 4,000 saved over the first five years of the loan.
You would also pay about $ 6,000 less in interest during that time, with more of your hard-earned dollars going towards the main balance.
If and when fixed rates rise, the ARM will offer more value as spreads widen.
Not bad, but is it worth the risk? Well that depends on several factors.
As mentioned earlier, this could be a great move if you don't plan on staying in the house long or holding the mortgage for the full term of the loan.
But interest rates will likely go higher so once the ARM adjusts, you can pay the price later. And it could be more difficult to refinance in the future …
Risk tolerance, age (retirement), job status, investment strategy and downright stress also play a role. So do a lot of math and compare different scenarios before deciding on something!
Put simply, you are taking a risk when you go for an ARM (hence the discount), so take a close look at the numbers versus fixed-price options.
While a variable rate mortgage offers financing at a discount, it comes with a lot more uncertainty, especially in today's marketplace.
And if paying off your mortgage is really a goal, a fixed-rate mortgage is generally the best option for most.
Tip: If you are buying a owner-occupied property that you plan to later rent out for the long term, a fixed-rate mortgage can be a good choice as you will likely keep the loan for a long period of time.
And chances are that you won't want to refinance the loan as the financing is more expensive with investment property.
Benefits of Fixed-Rate Mortgages
- The interest rate will NEVER change
- Your monthly payment won't fluctuate
- Easier management of your finances / budgets
- Fixed rate mortgage rates are currently very low
- No stress about what the prices are doing (you can sleep at night)
- No refinancing required unless interest rates drop dramatically (but you can still do it if you need to)
- Just wrap your head around your head, no surprises
Disadvantages of fixed-rate mortgages
- Interest is usually more expensive
- Your monthly payment will be higher
- You pay more interest during the repayment period
- It might be more difficult to qualify for a higher interest rate mortgage
- You pay off your mortgage more slowly
- You build up equity more slowly
- You may decide not to refinance for fear of losing your low fixed rate
Advantages of adjustable rate mortgages
- Lower mortgage rate (at least initially)
- Lower monthly payment
- In the first few years you will pay less interest
- Build equity faster while the interest rate is lower
- Most ARMs are pinned for a period of time
- Caps and caps limit movements in interest rates
- You could sell / move before the interest rate even adjusts
- You can always refinance if rates go up and you qualify
- Interest rates can actually go down over time!
- You have extra cash for other expenses or investments
Disadvantages of adjustable rate mortgages
- Interest rates can rise significantly in a short period of time
- You may not be able to afford the higher monthly payment after the adjustment
- You could lose your home to foreclosure if you can't keep up with payments
- You can refinance again and again and never really pay off your mortgage
- Refinancing can be quite costly compared to keeping your original fixed rate loan
- You could be stuck with your high yield loan if you don't qualify for a refinance
- ARMs often have floor floors that limit whether the interest rate can actually go down
- You need to actively track mortgage rates
- You will likely be a lot more stressed out
- Your interest rate can determine whether you will move or stay
- Harder to budget accurately
- Time goes by faster than you think
(Photo: eckes / bernd)