Fixed Rates versus Adjustable Rate Mortgage
The most popular mortgage by far is the fixed rate mortgage. With mortgage rates at historic lows a fixed rate makes sense for many homeowners. Before assuming a fixed rate is right for you take a few minutes to consider the risk and reward of an adjustable rate mortgage (ARM).
Adjustable rate loans have an undeserved reputation as being risky. A former Fed Chairman classified most as “exotic”. The risk in having an adjustable mortgage is that the rate can change at predetermined dates and increments. What is important to consider however is that most adjustment mortgage are almost always guaranteed to save you money over the initial interest rate time period and often longer when compared to a fixed rate alternative. The risk comes in the adjustment periods.
For example a 5 - 1 adjustable rate mortgage offers a fixed payment for the first five years. After the fifth year the loan can adjust every year up or down based upon an index and margin used to calculate the adjustments. The adjustments are governed by caps, i.e. how big an adjustment can change on each anniversary. A 5 -1 ARM with a 5/2/5 cap means it has a start rate for 5 years. After five years the rate can adjust up or down 5%. After this first adjustment each year the rate can go up or down by 2%. The most it ever can go up is 5% over the start rate (lifetime cap). A better option (if comparably priced) is a 2/5 cap. Typically only offered on shorter term ARMS, this feature caps your first adjustment, and any in the future, at 2% with a lifetime cap of 5% over the start rate.
The following example compares two 5 - 1 ARMs to a fixed rate. For this example we will use a $200,000 loan for payment comparisons and also assume rates have increased on the first adjustment above the 2% cap. We will assume the worst case scenario with margin and rate increases resulting in an adjusted rate hitting the ceiling of 5%:
| 30 Year Fixed | 5-1 with 5/2/5 Cap | 5-1 ARM with 2-5 Cap | |
|---|---|---|---|
| Rate | 4% | 3.5% | 3.625% |
| Payment | $954.83 for loan life | $898.09 for years 1-5 | $912.10 for years 1-5 |
| Five Year Saving | $0 | $3,404.40 | $2,563.80 |
| Maximum 6th Year Rate | 4% | 8.5% | 5.625% |
| Year 6 Payment | $954.83 | $1,537.83 | $1,151.31 |
| Six Year Total Savings | -$3,591.60 (loss) | $206.04 | |
As the above example illustrates, the cheapest loan over a five year period is the 5 - 1 ARM with a 5/2/5 cap. Because of its high adjustment cap, it becomes the least affordable very quickly in year six in a worst case scenario of rising interest rates. The 5 -1 ARM with a 2 - 5 cap is the safest cheapest option for 6 years. Beyond year six the fixed rate mortgage is the clear winner in a rising interest rate environment.
When should you consider an adjustable rate loan? Consider one when you have a good sense of your time horizon for owning the home. Pick an ARM with a first term similar to your time horizon. You might also consider an ARM if you have the financial flexibility and income to assume more risk.
Remember rates are at some of the lowest rates in generations. If your time horizon is undetermined a fixed rate is probably best.