The conventional wisdom is that with mortgage interest rates about to climb, it makes sense to lock in a sub-5 percent fixed-rate mortgage while you still can—but maybe an adjustable rate mortgage (ARM) will save you money.
When fixed-rate mortgages are perceived to be at close to historic lows or the difference between fixed and floating rates is small, borrowers tend to favor fixed rates over ARMs because an ARM allows the monthly payments to climb higher.
ARMs are sometimes called floating-rate mortgages or variable rate mortgages. They begin with a fixed interest rate for a defined period of time which resets by adding a spread—an ARM margin—to the cost of the lender’s funds defined by a specific benchmark like the London Interbank Offered Rate (LIBOR). A 5/25 ARM would have its interest rate locked in for the first 5 years, reset each year for the 25 remaining years of the loan.
The major reason the interest rate on a 30-year, fixed mortgage is higher than for an ARM is that the lender assumes the borrower will take the entire 30 years to pay it back, putting the lender at risk of losing money on the mortgage if the bank borrowing rate goes up during that time frame. It’s hard to believe in today’s market with the U.S. prime interest rate at 3.25 percent, but a little over 33 years ago on December 19, 1980 the U.S. prime interest rate hit a record of 21.5 percent.
ARMs contributed to the mortgage meltdown
In the 2000s many home owners bought property with ARMs expecting to refinance if the rates ever got too onerous. After U.S. home values peaked in 2006 then started a swift decline, many borrowers found their ARMs resetting to higher interest rates while the owners were unable to refinance, because their home values had declined to the point where they owed more than their homes were worth.
The situation was worse for homeowners in the sub-prime market with bigger ARM margins who took out optional ARMs. These loans allowed borrowers to simply make minimum monthly payments that did not cover the entire interest cost. When payments reset, the interest not paid was added to the principal. The new payment was raised to not only reflect the rising interest rate but the additional total owed. Many borrowers could not afford the payments and lost their homes to foreclosure.
Do the math with an ARM
30-year fixed interest mortgages make the most sense for people who plan to be in their homes for that amount of time. They can sleep soundly knowing what their house payments will be every month. Most Americans stay in their homes for only 8-10 years, so over that time frame an ARM is often the better choice.
If you had taken out a 30-year fixed rate mortgage in January 2003 according to the Wall Street Journal the rate was 5.92 percent. A decade of payments on a $400,000 mortgage would have cost you $285,320, but if you had gone with a one-year adjustable rate mortgage which began at 3.99 percent you would have paid only $238,362, a savings of $46, 958. The interest rate did vary during that time frame, but it never went as high as the rate on the 30-year fixed loan. It also fell as low as 2.76 percent. You would have saved even more if you had paid down your principal with the money you saved since the monthly payment is calculated on the balance owed.
If interest rates do shoot up again, be aware that ARMs come with rate caps both over the lifetime of the loan—typically 5-6 percent—and also from one year to the next, in which case they’re typically 2 percent.
Examine your housing needs critically. If you can’t see yourself in your new home in 2044, then consider an ARM as a viable alternative to a fixed-rate loan—but learn from the past. Pay attention to rising interest rates and cut back elsewhere if you foresee your payments climbing.
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Advice for First-Time Home Buyers