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.