Fixed Vs. Adjustable Rate Mortgages (ARM’s): Which is Better?
This post may contain some Mr. Obvious type advice to some – but the fact that certain types of bank products still persist leads me to believe that it won’t be obvious to everyone. And if I can save a handful of readers out there from making an uninformed borrowing choice – it will all be worth it.
As a first-time (or even 2nd or 3rd-time) homebuyer, you are going to have a selection of mortgage products to choose from.
There’s a lot of goofy mortgage offerings out there with funky names like “Jumbo”, “Balloon”, and “Badonkadonk”. General rule: if you can’t tell what something is by the name, odds are very good that it’s not something you should buy.
The two most commonly accepted types of mortgages are fixed rate mortgages and adjustable rate mortgages (ARM’s) – also commonly referred to as variable rate mortgages.
Fixed Rate Mortgage Overview
Fixed rate mortgages are just as the name applies. The borrower and the lender have an agreed upon rate for the mortgage, it’s signed for, and that mortgage rate is fixed. In other words, it does not change, for the life of that loan.
Among fixed rate mortgages, you’ll most commonly see a 15 or 30 year mortgage.
The longer the term of a fixed rate mortgage, the higher the mortgage rate. For example, right now, 30-year fixed rate mortgage interest rates average 4.0%, while 15-year fixed rate mortgages average 3.2% APR – almost a full percentage point lower.
Why is this?
It’s all about risk.
When a lender lends you money, they are assuming risk that comes with the possibility of interest rates rising and the return on their investment in you (your loan) being worth less. At any point, the fed funds rate could change, pushing the going prime rate higher and mortgage rates typically follow suit. The longer the term of the mortgage, the higher the risk assumed by the lender. As a borrower, you have your rate locked in. There is zero risk that interest rates will rise on you – the contract you have signed with your bank guarantees they will stay the same.
As the borrower, you can also refinance your mortgage if you have locked yourself in to a rate that is higher than today’s rate. The lender, on the other hand, cannot do the same to you if they’ve determined that the rate you locked in with them is no longer favorable.
For this reason – fixed rate mortgages, by design, are very consumer friendly. You determine how much you should put towards your down payment and know what you’re going to get up front on the interest rate. No surprises or changes.
Adjustable Rate Mortgage Overview:
Then there’s adjustable rate mortgages (ARM’s).
ARM’s are the lending industry’s attempt to swing the pendulum of risk back in their favor, by design.
When you sign up for an ARM, you know what your introductory rate is and generally how long it lasts. But from there, it is connected to the prime rate and can change on you often. There is little risk to the bank, because if interest rates increase, they simply raise the rate on your ARM.
Why would any borrower sign up for something like this?
Well, that’s a good question. And one you should probably ask the sales guy urging you to choose it (if you haven’t already walked out of the building).
Because ARM’s are so blatantly higher risk to borrowers than fixed rate mortgages, lenders have to have a hook to get borrowers interested. That hook often comes in the form of a sexy teaser rate. A teaser rate is the initial interest rate you will pay for the loan. For example, right now, I was able to find a number of ARM’s with a teaser rate in the 2.7% – 3.0% APR range (lower than the fixed rate mortgage rate averages I highlighted earlier). Often times these teaser rates are only good for the first month or so.
If you’re a borrower who doesn’t read all of the fine print or is susceptible to taking the bait – you might jump at the low interest rate, thinking you’re getting a bargain. But a year from now you might be paying an interest rate that is higher than the fixed rate you could have locked in. And 10 years from now, you might be paying a significantly higher rate. For this reason – much like with payday loans (which should be banned) – there is a predatory nature in the offering (albeit much less predatory and harmful).
Some ARM’s have fancy terms that will highlight various caps, so you might feel like there is some protection involved – but if you need a lawyer and a week of time to understand all of the terms, you should probably run away from the deal.
There are also “hybrid ARM’s” that have a fixed rate for a longer specified period of time, before turning to a variable rate. For example a 5/1 ARM would have a fixed rate period of five years before being adjust on an annual basis. A 3/1 ARM, 3 years, then every year. If you knew you were going to be at a specific location for just a few years, one of these mortgages might make sense. BUT, and this is key, the introductory period rate would have to be much more attractive than the current fixed rate offerings. Right now, that’s not the case at all. In fact, the average 5/1 ARM today has a 5-year rate that is higher than 15-year mortgages. Why not simply go with the lower rate, especially since it is locked in for more than 5 years?
Are there Any Scenarios is which an ARM would be Attractive?
One possible scenario where an ARM mortgage might make some sense is in a very high interest rate environment, where the odds of the interest rate declining in the future are likely – and a refi would not be necessary if the ARM self-adjusted (potentially saving the borrower thousands in refi costs). Many ARM’s will be self-protected against this, however, by setting a “floor” clause that prevents the ARM from adjusting lower than the start rate offered or to within a specified percentage point lower than the start rate. You can also bet that in this type of interest rate environment that many ARM products would cease to be offered by lenders.
The reality is, we’re not in that situation today. Mortgage interest rates are near historical lows, and the odds of them going lower are slim to none. Today’s interest rate environment puts all of the risky squarely with the lender. In other words, there’s never been a better time for borrowers to get a fixed rate mortgage that will lock them in to a low long-term interest rate. So when you get sold the idea of an ARM, tell the guy, “Sorry, I know better”. Then, “See ya later, Pal”.
Fixed Rate vs. ARM Discussion:
- Do you or have you ever had an ARM? Why? And what have you learned?
- Have you been aggressively pitched an ARM?
- What is your current fixed or adjustable mortgage rate?
- Do you foresee any situations in which an ARM might be more attractive to you than a fixed rate mortgage?