Forget 30-year fixed-rate mortgages – that’s why you save with an ARM. more money
With mortgage rates hitting all-time lows this year, many people are looking for refinancing or a home purchase.
But should you get an adjustable rate mortgage (ARM) that has a fixed rate lead-in period – usually five, seven, or ten years – and then adjusts regularly to market conditions, or the more popular 30-year fixed rate mortgage?
Most experts will tell you that the latter is safer to go with. However, having taken out several types of mortgages over the past 17 years, I am convinced that an ARM will likely save you more money:
1. The long-term interest rate is on a downward trend.
It is certainly beneficial to know that your interest rate will never rise over a period of 30 years.
But the benchmark ten-year government bond yield is an important barometer of mortgage rates; if bond prices fall, interest rates rise. And bond yields have been falling since 1981.
It is very unlikely that the downtrend will change that quickly. That would require investors to be very optimistic about the economy (as faster growth can lead to inflation, which then undermines the purchasing power of fixed income and puts pressure on the Federal Reserve to raise rates).
Therefore, choosing an ARM is smarter because you pay a lower interest rate (during the fixed rate period) than a 30 year fixed rate mortgage. And if the ARM eventually fluctuates, you can assume that interest rates will still remain low.
2. It fits better with the average length of home ownership.
Too many people overestimate how long they will live and own in the same house. Since the average home ownership period is 8.5 years, it makes no sense to fix a 30-year fixed interest rate.
The more efficient way would be to do an ARM that is equivalent to a reasonable home ownership period. For example, if you plan to live in your home for 8-10 years, getting a 10/1 ARM (where the induction rate is 10 years) will be more cost effective.
A 10/1 ARM is usually between 0.25% and 0.5% cheaper than a 30-year fixed-rate mortgage. Why? Because the interest rates are lower when you borrow for a shorter period of time.
To illustrate, let’s compare a 10/1 ARM with an interest rate of 2.5% to a 30-year fixed-rate mortgage with an interest rate of 3%.
With the 10/1 ARM, the borrower’s monthly payment is $ 133 less, and after 10 years the balance drops 26% ($ 7,398 less). If the mortgage is not paid off by year 10 or the home is not sold, the owner can either refinance a balance less than 26% or let the ARM float.
3. Usually there is an upper limit on how much the course can be adjusted upwards.
One of the biggest fears among proponents of the 30-year fixed-rate mortgage is that after a fixed-rate period ends, interest rates will skyrocket – making monthly payments unaffordable.
This is simply not the case, as ARMs typically include several types of caps that control how much your interest rate can change at the end of each adjustment period. So there are no “endless” rate hikes unless your lender is trying to cheat you.
For example, in 2014 I got a 5/1 ARM with 2.5% interest. In 2019, the maximum it could be reset to was 4.5% for one year. The ARM could be reset by a further 2% up to a maximum of 7.5% in 2020.
But instead of resetting the ARM, I of course refinanced my mortgage to a 7/1 ARM at 2.6% interest with no fees.
4. You will be more disciplined.
Think of an ARM as a money coach who will teach you to stay in control of your finances.
Because you have a shorter time frame to reduce debt, you will be more motivated to pay extra capital each month, quarter, or year. The goal is to get your bankroll as low as possible before your introductory fixed income period is over.
A 30-year fixed-rate mortgage, on the other hand, is like your neighborhood gym: you barely go knowing you should. When you have three decades to pay off debts, the natural tendency is to sit back and take your time.
5. Higher rates aren’t necessarily a bad thing.
Things don’t happen in a vacuum. The yield on 10-year government bonds reflects the inflation and economic growth projections.
If yields and mortgage rates are rising, it likely means that inflation has increased (or is expected) because demand is increasing. So even if you have a higher mortgage rate, the value of your home will most likely be higher due to the strong demand.
Since the cost of home ownership is largely fixed, real estate is not only an inflation protection, but also an inflation game. In extreme circumstances where hyperinflation occurs, it is advisable to own tangible assets such as real estate instead of cash, which quickly loses purchasing power.
6. You have the ability to take action.
Let’s say you’re unlucky and interest rates rise aggressively during your ARM’s fixed income period – and they stay high after your fixed income period ends.
Before your ARM floats, there are a number of things you can do:
- Pay off more principal to lower future mortgage payments
- Refinance your mortgage before the interest rate fluctuates
- Revise your mortgage
- Sell your property
- Generate income by renting out a room, a floor or the entire property
Basically, you have plenty of time and options to take a wise financial move before your ARM is reset to a higher rate.
Choose your mortgage wisely
This is one of the most important decisions you will make when buying a home. Your decision will affect your monthly payment, how long it will take to pay off your mortgage, and how much interest you will pay in the process.
But whether you choose a 30-year fixed-rate mortgage or an ARM, you can at least be happy to benefit from record-low mortgage rates. Just do the numbers carefully and be honest with your predictions.
Sam Doge Worked in investment banking for 13 years before starting Financial samurai, a website for personal finance. He has been featured in Forbes, The Wall Street Journal, The Chicago Tribune, and The LATimes. Sign up for his free weekly newsletter Here.
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