With mortgage rates at historic lows this year, many people are looking to refinance or buy a home.
But should you get an adjustable rate mortgage (ARM), which has a fixed rate introductory period – usually five, seven or 10 years – then adjusts periodically based on market conditions, or the most popular 30-year fixed rate?
Most experts will tell you that it is safer to use the latter. However, having taken several types of mortgages over the past 17 years, here is why I am convinced that an ARM will probably save you more money:
1. The long-term interest rate is trending down.
It certainly helps to know that your interest rate will never increase over a 30-year period.
But the yield on the benchmark 10-year Treasury is a key barometer of mortgage rates; when bond prices fall, interest rates rise. And bond yields have been falling since 1981.
The downtrend is highly unlikely to change anytime soon. For this to happen, investors would need to be very optimistic about the economy (since faster growth can lead to inflation, which then erodes the purchasing power of fixed-rate bonds and puts pressure on the Reserve federal government to raise interest rates).
Therefore, choosing an ARM is smarter because you would pay a lower interest rate (during the fixed rate period) than a 30-year fixed rate mortgage. And when the ARM eventually floats, you can expect interest rates to stay low.
2. This corresponds better to the average duration of ownership.
Too many people overestimate how long they will live and own the same home. Given that the average tenure of housing is 8.5 years, it makes no sense to make a fixed rate of 30 years.
The most effective route would be to make an ARM that matches a reasonable home ownership period. For example, if you plan to live in your home for eight to 10 years, taking out a 10/1 ARM (where the introductory rate lasts for 10 years) is more cost effective.
A 10/1 ARM is typically between 0.25% and 0.5% cheaper than a 30-year fixed rate mortgage. Why? Because the rates are lower when you borrow for a shorter period.
To illustrate, let’s compare a 10/1 ARM with an interest rate of 2.5% versus a 30-year fixed 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 decreases by 26% ($7,398 less). If the mortgage isn’t paid off – or the house isn’t sold – by year 10, the homeowner can either refinance for a balance below 26% or let the ARM float.
3. There is usually a cap on the amount the rate can adjust upward.
One of the biggest fears held by proponents of the 30-year fixed mortgage is that once the fixed rate period is over, the interest rate will rise, making monthly payments unaffordable.
This is simply not true, as ARMs typically include several types of caps that control how much your interest rate changes at the end of each adjustment period. So unless your lender is trying to scam you, there are no “endless” interest rate increases.
In 2014, for example, I got a 5/1 ARM with an interest rate of 2.5%. In 2019, the maximum at which it could be reset was 4.5% for one year. ARM could reset another 2% in 2020, up to a maximum of 7.5%.
But of course, instead of allowing the ARM to reset, I refinanced my mortgage to a 7/1 ARM with an interest rate of 2.6%, no fees.
4. You will be more disciplined.
Think of an ARM as a financial coach that pushes you to stay on top of your finances.
Since you have a shorter time frame to reduce your debts, you will be more motivated to pay additional principal each month, quarter or year. The goal is to reduce your balance as much as possible before the end of your introductory fixed rate period.
A 30-year fixed mortgage, on the other hand, is like your neighborhood gym: you hardly ever go there, even though you know you should. When you have three decades to pay off your debts, the natural tendency is to sit down and take your time.
5. Higher rates aren’t necessarily a bad thing.
Things don’t happen in a vacuum. The 10-year Treasury yield reflects forecasts for inflation and economic growth.
If yields and mortgage rates are rising, it likely means inflation is high (or expected to rise) because demand is rising. So even if you have a higher mortgage rate, your home value will likely be higher due to high demand.
Since the cost of property is largely fixed, real estate is not only a hedge against inflation, but it is also an inflation game. In an extreme circumstance where there is hyperinflation, it is wise to own real estate such as real estate – instead of cash, which quickly loses its purchasing power.
6. You have the ability to act.
Let’s say you’re unlucky and interest rates rise aggressively during your ARM’s fixed rate period – and stay high after your fixed rate period expires.
Before your ARM floats, you can do a number of things:
- Repay more principal to reduce future mortgage payments
- Refinance your mortgage before the rate floats
- Overhaul of your mortgage
- Sell your property
- Generate income by renting a room, a floor or the entire property
Basically, you’ll have plenty of time and options to make a smart money move before your ARM resets to a higher rate.
Choose your mortgage wisely
It’s one of the most important decisions you’ll 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’ll pay down the road.
But whether you choose a 30-year fixed-rate mortgage or an ARM, you can at least be happy knowing you’re enjoying record-breaking mortgage rates. Just run the numbers carefully and be honest with your predictions.
Sam Dogen worked in investment banking for 13 years before starting financial samurai, a personal finance site. He has been featured in Forbes, The Wall Street Journal, The Chicago Tribune and The LATimes. Sign up for his free weekly newsletter here.