Choosing Between a Fixed or Adjustable Rate Mortgage

Before shopping for rates, we had to figure out what kind of mortgage loan we were going to get. The first decision was between a fixed-rate or an adjustable-rate mortgage. Quickly, here are some very general definitions:

  • Fixed rate mortgages (FRMs) provide a constant monthly payment for the life of the loan, no matter what interest rates do in the meantime. Common lengths are for 15 and 30 years.
  • Adjustable rate mortgages (ARMs) offer a lower monthly payment for a certain initial period, and then adjust periodically afterwards. Common initial periods are 1, 3, 5, and 7 years. For example, if you see a “5/1″ ARM, the rate and payments are fixed for the first 5 years, and then will adjust according to a pre-determined formula one a year after that. A “5/5″ ARM adjusts only once every 5 years. Usually they are also based on a 30-year amortization, but not always.

Here were my three main considerations for choosing between ARMs and FRMs:

How long do I expect to stay in the home?
I’ve read statistics that people tend to move about once ever 5-7 years, and that the average mortgage only lasts 7-8 years before being refinanced or paid off (usually from the sale of the home). But who cares about average? Everyone is different.

It’s true that if I bought a “starter home” that with the arrival of kids we might need a quieter neighborhood or more space. In our case, we ended up finding a home that has everything we need for the foreseeable future. While trying to be as objective as possible, if I had to lay odds I’d say that there is a 95% chance that we’d stay past 5 years, and 75% that we’d stay for 15+.

What’s the interest rate savings if I go with an ARM?
Here you’d have to look at current rate curves. At one unlikely extreme, if you’re getting the same rate for both types of loans, of course you’d go for the fixed. Right now, the spread is about 0.5% between a 5/1 ARM and a 30-year fixed mortgage, which is pretty narrow. In the past the spread has been as little as 0.1% and as high as 1-1.2%, possibly more.

Although many mortgages brokers will tell you “even if you end up staying longer than 5 years, you can always refinance”, that’s just not true. You can’t always refinance – check out all those sub-prime borrowers who can no longer get a loan anywhere. They are stuck with rates resetting in the 15% range!

And even if you can refinance, it might be ugly… What if your credit score drops in that time? What if lending standards continue to tighten? What if rates rise significantly? What if your home value drops and your loan-to-value (LTV) ratio is now horrible?

I think ARMs can be a smart buy if you can assess your situation accurately. Some people know they’ll be gone in four years or less. Who knows, rates might actually drop like we’ve seen recently. But no matter what there is an element of risk involved. With rates still at historical lows, we see the downside being a lot worse than any potential upside.

Do I want to rent it out?
This is one consideration I don’t always see mentioned. If I do end up moving, there is a very good chance that I’d like to make my home a rental property. With a fixed mortgage, again I have stability. Rents will rise with inflation, but my mortgage payment will always stay the same. I also don’t have to worry about obtaining a investment-property mortgage, as primary-home loans are usually much cheaper.

In the end, all the signs pointed towards a fixed-rate mortgage for our situation, so that’s what we’re getting. :)

Comments

  1. Everyone I know who has gotten an ARM eventually wished that they had not. There always seems to be some “gotcha” at the point of interest rate reset. As you pointed out, the spread is pretty small which means that you are getting paid very little to take the risk. In fact I have recently seen some 15 year fixed rate mortgages at a lower rate than the 5/1 ARMs at the some financial institution.

  2. I never gave thought to the notion – “what if I can’t refi”….excellent point

  3. “with the arrival of kids we might need a quieter neighborhood ” ????? Dude, all the single people and retirees WANT the quiet so that means AWAY from the kids…. Go for quiet now, and go for the kiddie neighborhood with parks and schools and playing in the street when you get the kids….. You’d make lots of “friends” if you were the only ones with kids around 8-|

  4. Joseph Sangl says:

    AND with rates at historical lows again, it makes a lot of sense to lock in the low fixed rate for 15 or 30 years.

    It’s a lot of fun figuring all of this out!

  5. Nice article. I just had one small thing to add regarding the FRM/rent paragraph:

    “Rents will rise with inflation, but my mortgage payment will always stay the same.”

    Barring increases in property tax and insurance costs.

  6. Check your mortgage contract. It may state in there that you must use the home as your primary residence, and if not, you must notify them of the change. I don’t know what they can do if you turn it into a rental — and I’m sure nobody really notifies them of this “change”, but just thought I’d mention it…

  7. “AND with rates at historical lows again, it makes a lot of sense to lock in the low fixed rate for 15 or 30 years.”

    It makes sense if you can put down 20% and still have money in reserve. If it means putting your whole saving for the downpayment and you have no money left, then it doesn’t make sense. Purchasing a home comes with a lot of expenses, I rather put down 10% and put the rest in reserve in case of a emergency.

  8. UpsideDown says:

    >check out all those sub-prime borrowers who can no longer get a loan anywhere

    The reason people are having difficulties refinancing isn’t simply because they are in a sub-prime mortgage. The primary cause of the refinancing problems is (even in a market with favorable interest rates) the fall in real estate values make it more difficult for homeowners to qualify to refinance. Of course, a person with a loan with little to no (or worse yet negative) amortization up front will statistically have a lower likelihood of refinancing since they have accumulated less equity in the home to refi, but a person in a 30 year fixed prime can find themselves in the same boat and not be able to take advantage of lower rates without having to pony up more down payment money for the refi.

    Of course the lesson learned in all this as you point out in the article is the fixed rate mortgage gives you the stability of the predictable payment regardless of what is happening in the market around you. In essence the homeowner when considering refinance options in the future, they always have the “I can do nothing at this time” card to play.

    However, part of the equation that need to be factored when considering the pros and cons regarding an ARM (or interest only, or negative amortization loans) is the likelihood that property values will increase before the interest rates will reset. Far too often when signing their loan papers they have placed a bet that their homes will increase in value before the interest rate reset. Of course, in today’s market, lots of people are losing this “bet”.

  9. “Right now, the spread is about 0.5% between a 5/1 ARM and a 30-year fixed mortgage, which is pretty narrow.”

    This may be true for conforming loans, but nowhere near correct for the jumbo loans that are often a necessity in expensive cities like LA, SF, NYC, etc. My mortgage broker (who came highly recommended and with whom I’ve been satisfied so far) said he could get a 5/1 ARM for 5.75% and a 30-year jumbo at 6.625%.

  10. “It makes sense if you can put down 20% and still have money in reserve. If it means putting your whole saving for the downpayment and you have no money left, then it doesn’t make sense. Purchasing a home comes with a lot of expenses, I rather put down 10% and put the rest in reserve in case of a emergency.”

    If you can’t put down 20%, then you can’t afford to buy a home. Putting down anything less than that should be reserved for seasoned investors. Thats what got us into the whole subprime mess in the first place. Why do you think the banks came up with PMI (private mortgage insurance). The banks wanted to protect themselves in the event you couldn’t make the higher payment that comes with a smaller down payment. Obviously people didn’t like paying PMI, especially because for a time, PMI was not tax deductible. So along came piggy back mortgages, where if you couldn’t put down 20%, you just got a 2nd mortgage at a much higher rate and that WAS tax deductible. Then, the banks got congress to allow PMI to be tax deductible, basically giving more people the opportunity to own a home. All this did though was lower and lower the down payment to 0% down (100% financing or no money down) and in many cases, 100+% financing where people walked away from closing with more money than the house was worth and now – EVERYBODY is paying for it.

    It all comes back to the old question which still remains – how much house can you afford? People, please base it off of being able to put 20% down, otherwise, keep saving until you get there.

  11. True…you can’t always refinance. Even if you can, there’s always the fees associating with it. Sometimes, it will take a few years to capture that fees.
    And of course, the mortgage brokers will tell you that because they want your business again when you re-finance.

    JT

  12. You mention moving your property to a rental and retaining your cheaper primary-home loan. This may not be possible as your loan will probably specify that you cannot later change your home to a rental. If you were planning on renting in a short time AND you anticipated a rise in rates you could lock in an investment property loan, but it sounds like that is not the case.

  13. MyTwoCents says:

    Very good points made, Jon – I will probably recommend that my boss at work read this. He’s currently in the process of buying a house and had, at least over summer, talked about getting an ARM instead of a fixed. Especially with the recent rate cuts, I think that getting a fixed could help save him some money.

    As Eric pointed out, down payment does matter a bit; however, that’s not something that I know much about in his current situation so that’ll have to be something he figures out based on his current financial situation.

  14. I’d say pick the 30 year. The 5 year didn’t offer me enough leeway.

    I have an ARM right now that will come due in June. So we’re going to refi. No big deal. But looking back I was convinced I would move out of my home within 4-5 years. 6 years later I’m in the same home and have little desire to pick up and move. My wife and I assume we’ll stay in our home for another 5-6 years – barring a sudden 300-400k windfal/inheritancel that makes buying in another area possible – and by then we’ll have a kid who must be in a good neighborhood for school anyway.

  15. Ted Valentine says:

    Eric if that’s the case then you’re buying too much house or not ready. You put 10% down and you’re paying PMI which eats up the savings on the lower rate. Aside from the other risks to an ARM and putting less than 20% down, how’s that make sense? You’re right about the expenses, but if you keep your payment to 1/4 of your monthly income you will be ok.

  16. I have never heard of a first mortgage not allow you to rent out your property down the road. You have to use it as your primary house initially (something like move in and make it your permanent residence by X months and for X long), but how can they control what happens in the future?

    I’m not saying this doesn’t exist, but it just doesn’t pass the common sense test to me. How would they enforce it? Anyone have a sample contract that says this?

  17. “If you can’t put down 20%, then you can’t afford to buy a home. ”
    Let’s say, you got hurt and couldn’t work for a while, plus you had a leak in the roof that cost 5K to fix, plus the property tax thats due. Since you put all your money for the downpayment, you had no cash reserve. If you did a 80/10/10, than you would be able to get through this tuff time. In life, unexpected things happen, thats life.
    You shouldn’t put down 20% if thats all you have.

  18. Good point on dropping home values affecting loan-to-value ratios also making refi’s potentially difficult.

    I have friends who got ARMs a while ago and are pretty happy – they can still refi now and get even lower rates.

    You can get FRMs with less than 20% down. I don’t see anything wrong per se with putting down less than 20% – it just increases the risk level and also potentially the interest rates. I’m not really liking the idea of paying 8-10% interest on a piggyback loan or paying PMI.

  19. As a current landlord of a townhouse that I lived in initially, you can change from owner-occupied to rental as long as it’s after some period of time (eg 90 days from closing…it’s usually short). There is no reason to even tell the bank.

    The bank will only care if you don’t make payments. Otherwise, there are no probs at all.

    You should at least consider the total difference in ARM vs FRM over the guessimated time you’ll live there. It could be substantial. Just another thing to consider.

    All in all, being you don’t know for sure if you’ll rent it and you don’t know what rates will be if you do, it’s a crapshoot. Go the direction you think you are most likely going to do.

    Good luck!!

  20. Billy Daniel says:

    PMI is now deductable !!!!!!!

    Mortgage insurance deductability for 2008 | PMI
    A provision that allows homeowners to treat mortgage insurance premiums the same as interest has been extended past 2007 through 2010. The deduction applies to premiums paid or accrued (including for prepaid mortgage insurance) on acquisition (not on refinancing) debt for mortgage insurance. The deduction is phased out for taxpayers (both single and married filing joint returns) with adjustable gross incomes over $100,000.

  21. Guy said “If you can’t put down 20%, then you can’t afford to buy a home. Putting down anything less than that should be reserved for seasoned investors. ”

    I disagree. Not only is putting down 20% unrealistic in some areas of the country put it has to do more with the monthly payments that you are making. As Jonathan said you take on more risk and could have a higher interest rate but if you get a fixed rate and have a monthly pmt that is reasonable I don’t see a reason why it can’t be done. Costs will be higher because of PMI put for some it’s worth paying a bit more for to have the comfort of being a home owner. I’m with Eric if you have to use all of your total cash savings to get to 20% you probably should keep some of the cash in case of an emergency.

  22. For a first time homebuyer like me, I think it’s better to have 20% saved, but go with an (up to) 97% LTV FHA loan. I am within the income limits for this loan. I plan to get a reasonably priced 30-year fixed rate loan and still have the cash in savings in case I need it to make any emergency payments. I also would sooner buy the home than wait until I have a 30%+ down payment saved.

  23. I’ve rented out several homes I originally declared as my “primary.” Lenders don’t care. As long as you pay the mortgage nobody will know or care.

    Additionally, a “change in circumstance” can cause you to move out of a home and rent it.

    Ralph mentioned rising property taxes but I believe Jonathan lives in CA so that’s not much of an issue.

  24. Rule of thumb is in a rising interest enviornment get a fixed. In a sinking interest enviornment go with an ARM. As you noticed though, the spread isn’t much of a difference right now.

    If you are putting 20% down, a long term fixed makes sense since you can lock in a low interest rate for a long time.

    If you are putting less that 20% down, that 2nd mortgage will be pricey and you’ll probably want to refi it into the first down the road, which may be a good reason to get an ARM with a fixed period of 5 years…

    As long as your income is good, you can refi into a long term fixed when rates bottom out and start to creep up…

    When doing a 30 year fixed, another thing to consider is paying points – do a calculation of when they pay for themselves. Also when buying a home you can deduct the points immediately, when you refi with points they have to be amortized.

    My loan which I think was the best one possible for my situation (when I refied), is a 30 Year fixed with 15 years of Interest Only payments. Everything I pay is deductible, I can invest the money I’m saving by not paying priciple, and the rate is locked for 30 years… at the end of the first 15 years it will be the equivalent of a 15 year fixed.

    I plan to possibly rent out my place when I upgrade to a new house, so the 30 year fixed made a lot of sense…

  25. The 30 year fixed rate does sound like the better move for you. I wish more people would stop and give this some serious thought befor ejust jumping in. Too many people see a rate and forget that there is more to the story than a lower rate. Way to think things through!
    Ed Nailor

  26. Fixed rates put my mind at ease during times when rates are going up.

    Jon, Is that your house in the picture? Either way, I like it. I’ve been looking for an old 1920′s craftsman style house to buy. Here (Atlanta area in Georgia) you can get a good fixer-upper for around 120 – 200K depending on the location.

  27. I’d say put as little down as possible, and always go with fixed. The ARM was really designed to stretch the market so more people could buy more homes – its not for YOU its for THEM. If you have to pay PMI, so you don’t empty out your savings, keep in mind PMI is designed with 20% equity in mind. Once you have 20% equity, either by extra payments, some sweat equity projects on the house, or a rise in property values, you can get a BPO (broker’s price opinion) appraisal on the house and if you’re at 20% equity you can have the PMI payments stopped.

    You also always have the option to make extra payments, rather than refinance – it doesn’t change your rate or your payment, but it makes the rate less relevant, because there is suddenly less principal (so every future fixed payment is paying more principal than originally scheduled.). Just google for “loan amortization with extra payments” – there are a number of excel spreadsheets available (it even came with some older versions of excel).

    In our case, when we bought our house we bought more than “we” needed, but much less house than we qualified for. Now 10 years down the road the “we” got bigger and the house seems to have shrunk! Now I’m feeling a little bit like we didn’t buy enough house. A house is still for most people THE Major Investment vehicle – so make sure you pick it like the investment it is. Location, Location, Location still governs. I find it interesting to watch the flip-it shows on TV, they by a 2-bedroom in CA for 800K and work on it for 6 weeks and sell it for 1.2M. Its not like that at all here!

    My Rules of thumb:
    It actually IS Location that governs.
    You need at least a full point rate change to refi (better 1.5-2).
    Invest in your own debt first (it has a guaranteed rate of return).
    A house is usually your single largest investment.
    Stay with fixed.
    Rates mean less if you make extra payments.
    Assume you will be there longer than you might think.

  28. I was not aware that PMI was deductible….thanks for pointing that out.

  29. toasty aroma says:

    I would do a 15 year fixed rate if I could afford it. With interest rates at a low, it would be nice to get locked in. Also the 15 year saves a ton of money over the 30, if you can afford the difference in monthly payments.

  30. Get as big a house as you can get a mortgage and then file for bankruptcy. In most states you cannpt be evicted from your home even after bankruptcy. Wait for 7 years and start over again.

  31. Guy said: “If you can’t put down 20%, then you can’t afford to buy a home.”

    That’s not true at all. It just means you cant afford to put down 20%. Down payment is a question of current cash reserves, affordability is a matter of cash flow. If you are fresh out of college and you earn at a nice clip and want to buy a house, you don’t have to wait until you have 20% down to say you can afford the house. Although with the lending standards tightening it would be harder to get 95 – 100% financing.

  32. Cooper's Dad says:

    I also have mortgaged a home that was initially owner-occupied (for about five years) and then became a rental. As the mortgage included escrowing for property taxes and insurance (not to mention my strong desire to have my Form 1098 mailed to me for the tax deduction), I HAD to inform the lender of my change of address. If they were so inclined, that should have tipped them off to the property’s change in status. Although the lender did not take action to enforce the loan’s “owner-occupied” requirement, they certainly could have (and others may in the future) for these reasons:

    1. If they have sold the loan in the secondary market, the investors may have recourse against the seller (my lender) as a term of the sale of the mortgage. This would incent the lender to take a more hard line against rental property mortgagors.

    2. As the industry responds to the sub-prime crisis, it would be naive not to expect lenders to look at other types of lending activity for ways to tighten up and reduce the risk of similar catastrophes in other loan products.

    3. Even if #2 does not occur by the industry’s own action, the federal government, which will likely take an even bigger bath for the sub-primes, may clamp down through additional regulation that would address “unauthorized” income property loans that are still booked (and priced) as owner loans.

    Having said all this, it’s all forward-looking. Today, there’s not much lenders are doing to prevent borrowers from converting primary residences into income properties, so for now, it’s probably still safe.

  33. >I have never heard of a first mortgage not allow you to rent out your property
    >down the road. You have to use it as your primary house initially (something
    >like move in and make it your permanent residence by X months and for X
    >long), but how can they control what happens in the future?

    Answer: I’ve NEVER read a mortgage contract for a primary residence that addressed anything about future use of the residence, and I’ve signed many mortgage agreements.

    >I’m not saying this doesn’t exist, but it just doesn’t pass the common sense
    >test to me. How would they enforce it? Anyone have a sample contract that
    >says this?

    Answer: I doubt it exists, and if it does, they wouldn’t want to enforce it anyway. The bank wants timely mortgage payments–nothing else. Heck, in purchasing a couple of rental properties I’ve assumed non-assumable mortgages. This clearly violates the “due on sale” clause of the original mortgage-holder’s note, but let me beat this dead horse: banks want nothing more than timely mortgage payments. In neither case did the bank question the fact that mortgage payments were made by an entity other than the original mortgage-holder.

  34. A few things…

    I would love to see a post specifically addressing renting out your first home after you move on to a bigger house. I seem to recall something about “owner occupied” in my loan terms. It jumped out at me as I knew all along I would eventually rent my current home out when I moved up.

    (At the moment, I’m waiting for the housing crash of ’09-’10) : )

    I’m putting off some major home expenses in the house I live in now (Water heater, dishwasher, roof) because I figure when I rent this house out, those can be BUSINESS expenses and offset income from the home. (I’m assuming they can be business expenses…) If I buy them now, I may get a little benefit out of them, but none of the tax deduction. (In particular, I’m thinking of the roof…)

    So one thought I had for a first time home buyer like Jonathan. If you were to rent out a portion of your home (even a bedroom) I wonder if you could write off a lot of your essential new home purchases as business expenses.

    For example, when you buy a home, you need to buy things like ladders, lawn mowers, tools, paint, etc. Could these items be considered part of your “rental property business” and deducted? Perhaps there is a tax guy on here.

  35. Jonathan please tag this post with ‘Real Estate’ instead of ‘General’

  36. Done!

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