Let me start out by saying that I have a bias in favor of fixed mortgages, especially in this time of historically low rates. The logic is this: Why wouldn’t you lock in now and enjoy the certainty of a nice low rate for the full life of your mortgage?
The vast majority of homeowners in America have a 30-year fixed mortgage.
But homeowners should step back and look at their life plan before jumping into a 30-year fixed loan. If you plan on staying in your home all the way through retirement, then great, a fixed mortgage is probably the right decision for you. The average rate for a 30-year fixed loan is approximately 4 percent with 0.5 points paid at closing, according to Thursday’s Freddie Mac Primary Mortgage Market Survey. This is significantly lower than the historical range of 6.5-8.5 percent.
However, many homeowners in the U.S. only end up staying in their home for five or 10 years. So one needs to carefully consider how long they think they’ll be in their home when they seek a new mortgage.
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A hybrid adjustable-rate mortgage can lock in your interest rate for a fixed number of years. Then it adjusts each year based on a predefined index plus a margin that is calculated each year following the fixed rate period. Popular versions are the three-year adjustable-rate mortgage, the five-year adjustable-rate mortgage, the seven-year and the 10-year. Homeowners can enjoy significant savings over a conventional 30-year fixed mortgage if they feel relatively confident in their estimate of how long they will be living in their home, and they are willing to take some risk if they are wrong on their estimate and interest rates rise.
For example, let’s look at a 5/1 adjustable-rate mortgage. That’s a mortgage which has a fixed rate for five years and adjusts each year thereafter over the 30-year life of the loan. According to Freddie Mac, the current average for a 5/1 is 2.9 percent versus a 4 percent interest rate for a 30-year fixed loan, with approximately the same fees and points paid at closing. So let’s say you think you’re going to be in your home for five years. On a $300,000 loan, that will save you more than $10,000 on your monthly payments for the first five years, the fixed rate period of the loan.
But if you’re wrong and you stay longer in your home, and interest rates rise, you could suffer higher payments after the fixed rate period expires. Most adjustable-rate mortgages have a cap on the amount the interest rate can rise each year, which is often in the 2 percent range. And many have a lifetime cap of a 6 percent increase. If you have your lender run some “what if” scenarios for you, you’ll see that you can absorb an interest rate increase for some time after the fixed period of the ARM expires, and still be better off than locking in on a 30-year fixed loan.
It’s a personal decision
I am certainly not recommending adjustable-rate mortgages for everyone, because it’s really a personal decision based on your individual circumstances.
But let’s say you’re a young couple in a starter condominium with kids on the way, and you’re upwardly mobile in your career. You know you’re going to need a bigger home a few years down the road. You’d be a prime candidate for an adjustable-rate mortgage. In that scenario, you can take all that money you’ve saved each month and put it in a 529 plan for the kids to help fund their college tuition.
Just make sure you take the time to sit down and do some thoughtful life planning, and carefully consider the pros and cons of an adjustable-rate mortgage before defaulting to the typical 30-year fixed-rate mortgage.
Tom Reddin, former president of Charlotte-based LendingTree, writes an occasional column for Business Sunday about mortgages and home ownership. A version of this column previously appeared on his blog, MortgageRates.us. He runs Red Dog Ventures, a venture capital and advisory firm for early stage digital companies. Follow him on Twitter at @USRates.