Why an ARM May be Better than a Fixed-Rate Mortgage
Why an ARM May be Better than a Fixed-Rate Mortgage
Are you sure that a 30-year fixed-rate mortgage is the best home loan for your needs. For some borrowers, it may make more sense to consider an adjustable-rate mortgage instead. Yes even in these times of low rates.
Many borrowers are scarred by the housing crisis and fears of ARMs resetting to unaffordable payments. The news media constantly portrays adjustable rate mortgage as risky or predatory. Borrowers have been reluctant to assume the risk in their mortgage loans lately, with many of them opting for the predictable 30-year fixed-rate mortgage. With rates so low it hard not to just take a 30 year fixed.
For a time, taking that extra security didn’t cost much, since the adjustable rates weren’t that much lower than the fixed-rate options. But today, the rate spread between the 30-year fixed-rate mortgage and the 5-year ARM has widened to historic levels, some say. The spread between the two got very low right before the housing bust.
Rates on 30-year fixed-rate mortgages began increasing in October yet ARM rates have remained relatively stable.
Assuming say a $300,000 loan amount, a 30-year fixed-rate mortgage at 5.13% means a monthly payment of around $1,634. The borrow after five years would have paid about $74,053 in interest.
As a comparison, a 5/1 hybrid adjustable-rate mortgage at 3.83% offers significant savings. For the first five years, the monthly payment would be $1,403, and you’d pay approximately $54,771 in interest over those five years. So, for a borrower who plans on moving within five years anyway, they’d save as much as $19,283 by financing with an ARM.
But what happens in 5 years. The interest rate on the loan will begin to adjust to market rates. There are usually caps on how much it can adjust. Most common is 1 or 2 percent per year. There are also longer fixed terms so instead of a 5/1 ARM a borrower could choose a 7/1 or a 10/1 depending on their needs. The longer the fixed term the higher the rate will be.
Why the spreads are high
Blame inflation expectations for causing the wide spread between fixed and adjustable rates. In the near term, the markets expect low levels of inflation. But over the medium to long-term, they expect high inflation. Once the economy picks up expect that the Fed will raise key interest rates to protect against inflation. From the investor’s perspective, rates have to be higher on a 30-year product because the dollars they’ll collect at the end of the term will be worth less than those collected at the start, if interest rates rise.
With an ARM loan, the rate is fixed for a much shorter amount of time so the initial mortgage rates can be priced lower. Instead of the banks assuming the inflation risk, the borrower does because it’s unknown what they’ll be paying when the mortgage adjusts at the end of the fixed-rate period.
Basically Longer-term interest rates respond more to the potential for inflation down the road where as short-term interest rates respond much more to what the Federal Reserve does.
So if you are in the market for a mortgage, you might want to take a look at an ARM.
