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Why Adjustable-Rate Mortgages can be Better than Fixed-Rate Mortgages

By
Joe Taylor Jr
  • Loans
  • 6 minute read

Life has its ups and downs. It brings the joy of meeting your perfect partner… and then all too often the misery of you and your soul mate drifting apart. You come into a fortune… and then lose it in a Bernie Madoff-style scam. You get a fantastic new job… and then a new boss comes along who hates you. The point is, you can’t predict the future, and that means you’re constantly weighing hopes against fears and trying to make realistic assessments of the risks and rewards you face.

One such weighing that may not have occurred to you before arises when you decide on the kind of home loan that’s going to suit you best. Should you opt for the certainty of a fixed-rate mortgage (FRM), which, if interest rates rise significantly, might save you a small fortune? Or should you gamble on your personal circumstances making an adjustable-rate mortgage (ARM) deliver even more attractive savings? It’s not as easy a choice as you might think.

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Fixed-rate mortgages’ big advantage

In his 2010 paper, International Comparison of Mortgage Product Offerings, Dr. Michael Lea found that Americans love long-term FRMs. Indeed, they comprised well over 90 percent of home loans originated in 2009. At the end of July 2013, they were still making up 94 percent of all new applications, according to the Mortgage Bankers Association. And it’s plain to see why. Especially during times of uncertainty, it’s reassuring to know that every monthly payment you’re going to make over the next 15 or 30 years is going to be exactly the same as the first.

Among the nations Dr. Lea studied, the United States is unique in its citizens’ affection for long-term FRMs. Indeed, many countries (including Australia, Ireland, Spain, Switzerland and the U.K.) don’t have them at all.

What’s a hybrid ARM?

The alternative to a long-term FRM is a hybrid ARM. These offer a fixed rate for a specified period, usually one, three, five, seven or 10 years. So a 5/1 ARM is fixed for five years (the “/1” indicates how frequently the rate can be adjusted after the initial fixed period), a 7/1 for seven years, and so on. As a rule, the longer the period your rate is fixed, the higher the initial interest rate you’re going to pay.

At the end of the fixed period, the rate floats (sometimes only upwards, depending on your deal) in line with a published index that should be specified in your mortgage contract. Indices that are commonly used include ones linked to U.S. Treasury rates, the Cost of Funds Index (COFI) and the LIBOR index. Your lender may be borrowing at those rates and still needs to make a profit, so your contract should also normally specify a “margin,” which is the amount you have to pay above the published rate.

FRMs’ big disadvantage

Of course, you have to pay a small premium for the certainty that having a fixed rate for 15 or 30 years brings. At the beginning of August 2013, Freddie Mac calculated that the average rate for 30-year FRMs was 4.39 percent with a 0.7 point, while that for 5/1-year ARMs was 3.18 percent with a 0.6 point.

Actually, that’s not such a small premium. Key the numbers into a mortgage calculator, and you find that, on a $100,000 home loan, monthly payments come in at $500.17 if you have a 30-year FRM. With a 5/1-year ARM, they’re $431.37 — but only for the first five years.

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Are ARMs a gamble?

In the good-old, bad-old days before the credit crunch, ARMs were seen as inherently risky. And, back then, many of them were. But today there are fewer “exotic” versions of these loans. True, you should still read your mortgage contract very carefully, and make sure you fully understand all its implications, but you’re much less likely than you once were to find “gotcha” clauses.

Still, there’s no doubt that ARMs bring with them more risk than FRMs do. By law, virtually all ARMs come with caps on the extent to which their rates can rise, but it’s a good idea before signing to model some worst-case scenarios using a mortgage calculator. Remember, right now, many economists are predicting that the current trend in rising mortgage rates is likely to continue — and could accelerate.

When an ARM is a good choice

By now you may be wondering why this article has the headline “Why adjustable-rate mortgages can be better than fixed-rate ones.” There are two main reasons:

  1. Like rates, home prices are on an upward trend, and it may be a good idea for those with solid prospects to get a foothold on the housing ladder while they can. If they leave it too long, they may find themselves priced out of the market.
  2. Many people are confident they’re going to move again within a limited number of years. There’s no point in paying that premium for 15 or 30 years of certainty if you’re going to need a new mortgage anyway in another five or 10 years.

That second point is particularly persuasive. The U.S. Census Bureau says that, in 2010/11, 11.6 percent of Americans changed their residence. And that was the second-lowest proportion on record. Normally, more of us do. So if, on average, the entire population moves more often than once every decade, why do more than 90 percent of homeowners pay more than they have to to lock in rates for up to three decades? Of course, an FRM makes sense for those who are going to live in the same home for a very long time, but, statistically, many of us are wasting serious sums of money.

And so we’re back to where we started: making realistic assessments of the risks and rewards we face. Few of us know for sure when we’re next likely to move home. But we can make smart guesstimates and feel confident that we made the best decision with the information we had available.