Fixed-Rate Mortgages vs. Adjustable-Rate Mortgages

May 10, 2011 No Comments »
Fixed-Rate Mortgages vs. Adjustable-Rate Mortgages

Mongoose vs. Cobra. Coyote vs. Roadrunner. Pirate vs. Ninja?  And finally, fixed-rate mortgage vs. adjustable-rate mortgage.  Yes, we’re talking about the greatest rivalries of all time.

So what’s better, the boring old fixed-rate mortgage or the more provocative adjustable-rate mortgage (ARM)?

During the housing boom, homeowners often chose adjustable-rate mortgages as a means to qualify for a home they probably wouldn’t be able to afford with a traditional fixed mortgage.

But times have changed, and adjustable-rate mortgages have now fallen out of fashion with fixed-rate mortgage rates hovering near record lows.

In fact, fixed-rate mortgages account for more than 90% of the purchase money mortgages and refinance loans being originated nowadays.

Sure, fixed mortgages are definitely more popular, but that doesn’t mean they’re any better.  It’s just a matter of preference for most.  And as homes become less and less affordable, the popularity of ARMs will rise once more.

Fixed-Rate Mortgages Are the Default Option

When taking out a mortgage, most people tend to choose a fixed-rate mortgage, making it the default option.  The most popular of the fixed mortgages is the 30-year fixed, seeing that the payment is fixed for the entire term of the loan, and the long amortization period keeps monthly payments low.

The 15-year fixed-rate mortgage is also pretty popular, but because the entire balance must be paid off in half the amount of time, monthly payments are much higher.  That means fewer borrowers are willing or able to choose one.

Then there are adjustable-rate mortgages, which most borrowers tend to avoid unless they are extremely savvy, or instructed to do so by their broker or loan officer.

I say savvy because some folks will gamble on the initial interest rate discount afforded to ARMs despite the associated risk of a higher interest rate in the future.  So you need to know what you’re doing when selecting an ARM.

However, there are also those borrowers who must take out an adjustable-rate mortgage to qualify because the interest rate is lower.  Typically, the real estate agent, broker, or loan officer will float the ARM option to the borrower, whether it’s in their best interest or not.

What Type of ARM Are We Talking About?

The big question is what type of adjustable-rate mortgage are we dealing with?

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.  There’s even an option that is fixed for 10 years before its first adjustment.

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

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 if it’s an ARM.

All of these ARMs are amortized over a 30-year period, meaning they will take 30 years to pay off, assuming you hold them until maturity (which most borrowers don’t).  So in that respect they are similar to fixed-rate mortgages.

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

ARMs Go Up and Down

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

So an ARM you obtain today will most likely adjust higher upon 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, even if it’s higher today.

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 fixed-rate mortgage.

For example, if you are buying your first home, but plan to move or upgrade to a better home as you start a family, an adjustable-rate mortgage might be the best option short-term.  And the money saved can be used for a down payment on the next home.

Additionally, the lower interest rate increases affordability, which is not only a plus, but may also be a necessity for borrowers cutting it close in the qualification department (sadly this type of behavior contributed to the current crisis and isn’t recommended).

Never choose an adjustable-rate mortgage just to qualify for a loan. If you can’t qualify for a loan at the fixed mortgage rate, consider holding off and renting for a while or buying a cheaper property.

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, assuming there isn’t a floor on the rate.

For example, many of these ARMs are tied to the 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/floor 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.  That’s why short-term ARMs are typically reserved for the very wealthy, who have the option to refinance or pay off the loan whenever they choose.

If you go with an ARM and don’t have the option to pay it off or refinance, you could be stuck with a rising payment, which could put your mortgage (and property) in jeopardy.

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%, while the 5/1 ARM is pricing around 3.50%.

On a $250,000 mortgage, you’d be 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 in the home long or hold the mortgage for the full loan term, it could be a great move.

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!

Put simply, you’re taking a risk when choosing an ARM (hence the discount), so take a hard look at the numbers compared to fixed rate options.

While an adjustable-rate mortgage provides financing at a discount, it comes with much more uncertainty, especially in today’s unsteady market.  It could be difficult to sell or refinance…

And if you really plan on paying off your mortgage, a fixed mortgage is generally the best option.

Pros of Fixed-Rate Mortgages

  • The interest rate will NEVER change
  • Your monthly payment won’t fluctuate
  • Easier to manage your finances/budget
  • Rates on fixed-rate mortgages are very low
  • No stress about rates (you can sleep at night)
  • No need to refinance unless rates drop dramatically (but you still can if need be)
  • Easy to wrap your head around

Cons of Fixed-Rate Mortgages

  • Interest rates are higher
  • Your monthly payment will be higher
  • You’ll pay more interest
  • It could be harder to qualify with a higher rate
  • You’ll pay your mortgage off more slowly
  • You’ll build equity at a slower rate
  • You may not refinance for fear of losing your low, fixed rate

Pros of Adjustable-Rate Mortgages

  • Lower mortgage rate (at least initially)
  • Lower monthly payment
  • You’ll pay less interest
  • Build equity faster
  • Most ARMs are fixed for a certain amount of time
  • Caps and ceilings limit interest rate movement
  • You might sell/move before interest rate even adjusts
  • You can always refinance if rates rise
  • Interest rates can actually drop!
  • You’ll have extra cash on hand for other expenses or investments

Cons of Adjustable-Rate Mortgages

  • Interest rates can rise substantially in a short period of time
  • You may not be able to afford the higher monthly payment post-adjustment
  • You could lose your home to foreclosure if you can’t keep up with payments
  • You may refinance over and over and never actually pay off your mortgage
  • Refinancing can be quite costly
  • You might be stuck with your high-rate loan if you don’t qualify for a refinance
  • You need to keep track of mortgage rates
  • You will be a lot more stressed
  • Your interest rate may dictate whether you move or stay put
  • More difficult to budget accurately
  • Time moves faster than you might think

(photo: eckes/bernd)

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