Here’s an interesting question: “What mortgage has the best interest rate?”
Before we dive in, “best” questions are always a bit difficult to answer because what’s best to one person could be the worst for another.
But we can still examine what makes one mortgage rate on a certain product better than another, in certain situations.
In a recent post, I touched on the different mortgage terms available, such as a 30-year, 15-year, and so on.
That too was a “best” article, where I tried to explain which mortgage term would be best in a given situation.
Related to that is the associated interest rate that comes with a certain term.
Longer Term = Higher Mortgage Rate
And an adjustable-rate mortgage will price significantly lower than a fixed-rate loan, as you’re guaranteed a steady rate for the full term on the latter.
This has to do with risk – a mortgage lender is essentially giving you an upfront discount on an ARM in exchange for uncertainty down the road.
With the fixed-rate loan, nothing changes, so you’re paying full price, if not a premium for the peace of mind.
That’s all pretty straightforward, but knowing which to choose could be a bit more daunting, and may require dusting off a calculator.
Currently, the popular 30-year fixed is pricing at 4.22 percent, while the 15-year fixed is going for 3.44 percent, per Freddie Mac data.
The hybrid 5/1 ARM, which is fixed for the first five years and adjustable for the remaining 25, is averaging 3.07 percent, and the one-year ARM is just below 3.00 percent (2.93%).
As you can see, the 30-year is the most expensive. In fact, it’s more than a percentage point higher than the 5/1 ARM.
On a $200,000 loan amount, that would be a difference of roughly $130 in monthly mortgage payment and nearly $8,000 over five years.
The one-year ARM would be even cheaper, though just slightly. And for a loan that adjusts annually, it’s a big risk in an environment where interest rates are likely at or near the bottom.
As mentioned, the low initial rate on the 5/1 ARM is only guaranteed for five years, and then it becomes adjustable for the remainder of the term. That’s a lot of years of uncertainty.
The 30-year fixed is, well, fixed. So it’s not going higher or lower. The ARM has the potential to fall, but that’s probably unlikely, given where rates are historically.
So What’s Best?
Well, that depends on a number of factors unique to you. Do you plan to stay in the home long-term, or is it a starter home you plan to unload in a few years?
If you plan to sell in the near term, you could go with the ARM and use those monthly savings for a down payment on a subsequent property.
Just be sure you have enough money to make larger payments if and when your ARM adjusts higher if you don’t sell or refinance.
Five years not enough? Look into 7/1 and 10/1 ARMs, which don’t adjust until after year seven and 10, respectively. That’s a pretty long time, and the discount relative to a 30-year fixed could be well worth it.
If you’ve got plenty of money and actually want to pay off your mortgage, a 15-year fixed will be the best deal for your money, as you’ll get the lowest, fixed rate available. The downside is the higher monthly payment.
As a rule of thumb, when rates are low, it makes sense to lock in a fixed rate. Conversely, if rates are high, taking an initial discount with an ARM may make sense.
And assuming rates fall shortly after, you can refinance to an even lower rate, thereby extending your fixed period a bit longer.
In the end, it may all just come down to what you’re comfortable with. For many, the stress of an ARM simply isn’t worth any potential discount, so perhaps a fixed mortgage is “best.”
Read more: What mortgage rate can I expect?