Should I Get an Adjustable Rate Mortgage (ARM) Or A Fixed Rate Mortgage?

Hello-

 

I thought we'd tackle this age-old question in the posts today.  There are a lot of factors here to consider, so what I thought I'd do is post a framework for thinking about how to answer the questions, and depending on the response, if people want to know more, do some actual math examples with some opinions as to what most people should do.  OK, lets start with some basics.  If you prefer, you can watch my video where we go over specific examples! 

 

What is an Adjustable Rate Mortgage (ARM) or a Fixed Rate Mortgage

 

Definition time! Most people understand Fixed-Rate Mortgages. You get a rate, (like 5%) a term (like 30 years, or 15 years), and the rate doesn't change until the loan ends, and the payment is the same.  ARMs have many more options. We'll deal with the common situations in this post. Most ARMs are 5-year and 7-year fixed rate terms. That means that the rate is actually FIXED for the first part of the term. So a "5-year ARM" is a "Fixed-Rate Mortgage for 5 years, and then the rate may change over the next 25 years". A 7-year ARM is fixed for 7 years, and so on. There are usually restrictions on how high the rate can go, and how fast it can go, but we'll leave those aside for now. There are less common products - like ARMs that adjust after just one year - but most of those are gone in the retail market after the havoc they played in the housing market just a short time ago.

Why you would consider an Adjustable Rate Mortgage (ARM)?

 

First off, the ONLY reason to get an Adjustable is that there is usually a lower rate associated with an ARM then with it's Fixed-rate counterpart.  Here's the basics of how it works:  The bank is willing to offer you a lower rate because their "risk" in extending you money over the long-term is much less.  If rates move up, they'll be able to move their rates up, and the loan will stay

profitable.  30-years is a long time to make a bet, and the banks are much more comfortable with shorter term bets.  So where did the risk go?  To you, dear mortgage holder, to you.  You are taking the risk that when the fixed rate term of the ARM ends, you are either: 1) In a position to pay off the loan (unlikely, unless you are going to sell the home)  2) Rates are lower/equal to when you got your mortgage 3) Your home has appreciated/you have built equity to the point where you can get a better loan and terms than before.

 

If those are all untrue, your mortgage rate will go up and your payments will too, sometimes painfully much.

 

So When Should I Buy an ARM?

 

Well, there are a couple of factors that dictate the When:  1) You think when the term ends that rates will be manageable and you'll be able to get in a fixed-rate.  2) The difference between the fixed rate and the ARM rate is so large, that you'll be able to pay down the loan much, much faster.  You should not use an ARM because that's how you can afford "more" house.  Not a good idea to use a short-term financial product to reach, unless you're expecting a significant increase in income before the term ends.

 

Examples between choosing ARMs vs. Fixed Rates

Let us look at some examples here.

With a little math and understanding of your risk, you can make the right choice for you.

Example #1

Loan #1:  5-year ARM, Rate @ 5.0, 30 year term

Loan #2   30 year Fixed Rate @ 5.3

 

Recommendation:  This is actually what the ARM market looked like for some time in the past couple of years.  There's not enough reason to get the ARM with just a .3 differential.  You're taking a lot of risk, for minimal reward.  You can probably save the same money on your own - risk free.

 

 

Loan #1: 7-year ARM, Rate @ 4.0, 30 year term

Loan #2 30 year Fixed Rate @ 5.3

Extenuating Factors: You have three kids and know you'll probably need/want a bigger house in five years or so.