30 Year Fixed Mortgage vs ARM

May 10, 2011 No Comments »
30 Year Fixed Mortgage vs ARM

Mongoose vs Cobra. Coyote vs Roadrunner. Pirate vs Ninja?

And finally, 30-year fixed mortgage vs adjustable-rate mortgage.

Yes, we’re talking about the greatest rivalries of all time.

So what’s better, the almighty 30-year fixed-rate mortgage or an adjustable-rate mortgage (ARM)?

Obviously this isn’t the easiest question to answer, despite fixed mortgages accounting for more than 90 percent of the purchase money mortgages and refinance loans being originated nowadays.

Both Loan Programs Last 30 Years

First things first, both loan programs are based on a 30-year amortization, meaning both will take 30 years to pay off, assuming you hold them until maturity (which most borrowers don’t).

The major difference is that the 30-year fixed is, ahem, fixed, while the ARM is, you guessed it, adjustable. By adjustable, I mean your mortgage rate can up, down, or sideways. This obviously presents some serious risk, assuming mortgage rates rocket higher.

The big question is what type of ARM are we talking about?

These days, it’s quite common to take out an ARM with a fixed-rate period, such as a 5/1 ARM or a 7/1 ARM.

The above examples would be fixed for the first five and seven years, respectively, before becoming annually adjustable. They’re known as hybrid ARMs.

This means you’ve got some breathing room before the interest rate adjusts up or down. That’s right, your mortgage rate can move up or down.

ARMs Go Up and Down

While this is true, mortgage rates are still near record lows, and will more than likely rise in the future.

So an ARM you obtain today will probably adjust higher at its first reset, meaning your monthly mortgage payment will go up. So if you can’t handle the higher mortgage payment, you may want to stick with the 30-year fixed.

But will you stay in the home for 5-7 years, or will you move. And will you refinance before that time? If there’s a good chance you will, an ARM could make more sense than a 30-year fixed mortgage.

If we’re talking about a short-term ARM, such as a 1-month or 1-year ARM, it better save you money early on. At the moment, mortgage indexes tied to ARMs are so low that your first rate adjustment should result in a lower rate.

For example, many of these ARMs are tied 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 caps allowed for it.

However, this low rate environment won’t last forever, so someone who elects to go with this type of ARM will likely suffer long-term.  Most will probably have to refinance or sell before that happens.

Does the Initial Discount Justify the Risk?

Be sure you’re getting a good discount on the ARM for taking on the long-term risk.

Currently, 30-year fixed mortgage rates are hovering around 4.75 percent, while the 5/1 ARM is pricing around 3.50 percent.

On a $250,000 mortgage, you’re looking at savings of $182 per month with the ARM, or nearly $11,000 over the first five years of the loan.

Not bad, but is it worth the risk? Well, that depends on a number of factors. As mentioned, if you don’t plan to stick around long or hold the mortgage for the full loan term, it could be.

But interest rates are likely heading higher, so you may pay the price later once the ARM adjusts higher. And it may be more difficult to refinance in the future…

Risk appetite, age (retirement), job status, investment strategy, and downright stress will also come into play, so be sure to do plenty of math and compare different scenarios before deciding on anything!

Read more: Adjustable-rate mortgage advantages.

(photo: eckes/bernd)

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