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Fixed vs. adjustable: What is the lowest cost mortgage? Thumbnail

Fixed vs. adjustable: What is the lowest cost mortgage?

Before the financial market meltdown in 2008, adjustable-rate mortgages (ARMs) were all the rage, especially for homebuyers who were trying to buy-up to a bigger, more expensive house. After the market collapse, regulators severely restricted mortgages, especially for borrowers with less than perfect credit scores. Since then, few have considered ARMs, fearing that rates would rise and their payment would, too. However, there is more to the story of ARMs. 

As with most common financial advice, it can work for many people, but not everyone in every situation. 

Refinance and save(?)

For years, we have been encouraged to refinance to a lower rate fixed mortgage to save money. Of course, “saving money” is a relative term as refinancing itself can cost $2,500-$3,500 per transaction. Lenders typically these closing costs to the outstanding balance creating the appearance of a “free” loan. 

It’s not every day that you agree to pay a half a million dollars

In addition, fixed rate mortgages can be expensive. Over a 30-year period, the interest cost alone on a $960,000 mortgage is $544,073. That’s right. The interest cost is actually more than half the cost of the amount borrowed! You will see this number on the Closing Disclosure Form which is required to be presented to you at the Closing (and you have to sign saying that you read it, too).  

If today is Wednesday, it must be time to refinance

More concerning is refinancing several times into another 30-year mortgage. Mortgages are expensive because interest is charged over a long period of time and homeowners do not stay in their homes for 30 years. According to the National Association of Realtors®, the median duration of homeownership in the US is 13 years[1] as of 2018. So, the idea of locking in a low rate may be appealing but, the reality is that most Americans are starting their mortgages over again before they are even half way through paying it off. 

What about ARMs?

This led me to wonder about adjustable-rate mortgages and when they might be a better fit for some people than a fixed rate mortgage. 

ARMs usually start out with a lower interest rate and then, at the end of the fixed period, the rate floats based on current interest rates. Common ARM terms are 3/1, 5/1, 7/1 or 10/1 ARMs which is short for an initial fixed rate of 3 years followed by adjustments every year thereafter, etc. 

When is an ARM cheaper?

To figure out when an ARM might make more sense, I did a comparison of a 30-year fixed rate mortgage to a 10/1 ARM. In this situation both the 30-year fixed and 10/1 ARM have fixed interest rates for 10 years. Assuming a home purchase price of $1.2 million, with a 20% down payment, the loan would be $960,000. I assumed an interest rate of 3.25% for the 30-year fixed  and 3% for the ARM.[2] 

Because the interest rate is lower on the ARM, the monthly payment is lower by $131 per month and the principal is paid down faster, too. After ten years, this results in a principal balance that is $3,187 lower than the fixed rate mortgage. 

What if we put that $131 monthly savings to good work? So, I added that savings to an extra principal payment each month. This reduces the balance further by the end of the 10-year period. 

The net result was a lower principal balance of $714,070 with the ARM vs. $726,603, a savings of $12,533. Now, I could have been more aggressive and decided to make the extra principal payments even larger but, you’ll have to decide what makes sense and what you can budget each month. It goes without saying that the quicker you pay off the mortgage, especially an ARM, the more you can save. 

When is an ARM a better idea? 

If you know that you will not be staying in your current home for the full term of the mortgage, an ARM will likely save you money. Even if you plan to stay put for 30 years, the averages are stacked against you—most people move before then. So, considering an ARM could be a lower cost choice. 

Don’t get temped by the fixed-rate nature of 30-year fixed mortgages. Consider your own situation. If you are buying a vacation home, consider how long you think you’ll really use it. If you talk to realtors in vacation destinations, they know that people tend to sell their homes sooner than 30 years because they aren’t using them anymore after a few years, the kids have grown up and moved away, or perhaps the owners are aging and need to downsize and simplify their lives. Turnover of homes in these locations is higher than places where people normally work and bring up a family. 

Caveat: If you take out an ARM and rates are higher after the initial fixed period, you may pay more in interest than with a fixed-rate mortgage. However, ARMs are very efficient. Over the life of an ARM, if rates go up and down you are only going to be charged the prevailing rate. With a fixed-rate mortgage, if rates go down even temporarily, you’re still stuck paying the higher fixed rate. 

The bottom line is, keep an open mind and consider how long you’ll be in the property before getting a fixed rate mortgage. 

If you have more questions about fixed vs. adjustable-rate mortgages, give us a call. We’re here to help. 

Lyman H. Jackson




Financial Planning Solutions, LLC (FPS) is a Registered Investment Advisor. FPS provides this blog for informational and educational purposes only. Nothing in this blog should be considered investment, tax, or legal advice. FPS only renders personalized advice to each client after entering into an advisory relationship. Information herein includes opinions and forward-looking statements that may not come to pass. Information is derived from sources believed to be reliable. Information is at a point in time and subject to change without notice. Such information may not be independently verified by FPS. Please see important disclosures link at the bottom of this page.

[1] Source: https://www.nar.realtor/blogs/economists-outlook/how-long-do-homeowners-stay-in-their-homes According to the 2018 1-year American Community Survey.

[2] Typical rates based on my review of several lenders in the Boston area as of 3/2/21.

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