When you select a mortgage program, you'll probably notice that there is a trade-off between fixed and adjustable mortgages. Adjustable-rate mortgages (ARMs) offer the advantage of a lower start rate when compared with fixed-rate financing. In exchange for removing some of the risk to the lender if rates rise, you get a lower rate. The bigger the difference in rate, the more sense it makes to choose an ARM over a fixed mortgage. Today, that advantage is quite pronounced. The difference between a fixed-rate 30-year mortgage and 5/1 adjustable-rate mortgage is 1.24 percent (as of May 1, 2014, according to Freddie Mac).
Test Drive a Hybrid ARM: How Much Can You Save?
How big a deal is that 1.24 percent differential? If you borrowed $300,000 at 4.29 percent, your payment would be $1,483. With a 3.05 percent 5/1 hybrid loan, your payment would be $1,273. But there's more to it than that. In five years, you'll have reduced your mortgage balance by $27,407 with the 30-year mortgage, but you'll have paid it down by $34,413 with the 5/1 mortgage. So the ARM will have put an extra $19,602 in your pocket during the first five years you own your home.
What happens at the end of the initial fixed-rate period? The hybrid converts from a fixed rate mortgage to an adjustable rate loan, resetting according to several parameters. ARM rates are based on an index, like the LIBOR. The lender starts with the value of the index and adds a margin to it. The margin represents income to the lender. So if the LIBOR index is at 1.2 percent when the loan resets, and the margin is 2.7 percent (a typical margin), adding the two figures gets you 3.9 percent. That number is called the fully-indexed rate.
However, that's not the only consideration. ARMs also come with interest rate floors and caps. There's a limit to how much the rate can increase or decrease, no matter what the index does, and there are limits to how high and low the rate can go over the life of the loan. So if a 5/1 has a start rate of 3.05 percent, and in five years the LIBOR index is 8.3 percent, you probably won't pay the fully-indexed rate of 11 percent (2.7 percent margin plus the 8.3 percent index value).
There may be an adjustment cap of three percent for the first adjustment and two percent for subsequent changes (this is typical), and there may be a lifetime cap of six percent above the start rate (this is also typical). So the adjustment cap would not allow the rate to go higher than 6.05 percent in Year 6. Over the loan's lifetime, the rate would not be able to exceed 9.05 percent (3.05 percent plus six percent).
The Case for the Fixed Rate Loan
Of course, while the average home buyer keeps the property from five to seven years, those buying their "forever" home have different priorities.
Robert Shiller, an economist and one of the developers of the Case-Shiller indexes which follow metropolitan home prices, says “with rates now relatively low, this could be an auspicious time to buy a house with a fixed-rate mortgage. That could make good sense for people who aren’t out to bet on the housing or mortgage markets but are instead focused on settling into a home for the long term.”
But why at this time? Shiller argues that “interest rates have been declining for decades now. Clearly, that cannot continue on the same track for another 10 years, because rates would have to turn negative.
“But, of course, inflation can rise — and it’s easy to imagine that both it and interest rates will rise substantially, creating a bonanza for home buyers who have already locked in low rates. And because rates are so low now, they could climb a lot once they turn.”
Shiller sees fixed-rate financing as a hedge against inflation. Most people see a home primarily as shelter, a place to live, and not as a strategic economic wager. There can be a short-term advantage when financing or refinancing with an ARM, but many like the certainty provided by fixed-rate mortgages. Shiller, apparently, agrees.