June 12, 2011

Considering a 30 year Fixed or an ARM Mortgage

 Generally I think that a fixed rate mortgage is a better bet than going with an adjustable rate mortgage (ARM).   I say that because the fixed rate is a guaranteed rate with no surprises or risks.   Of course the ARM's do have lower interest rates to start so they can save you money for the first few years.   After the ARM resets though you don't know what you 'll pay and it could be several percentage points higher than what a fixed mortgage would currently give you.   If you know you will move within a shorter period of time then an ARM can make more sense.   On the other hand, your plans don't always work out as you'd thought. 

Its a given that an ARM is going to save you on interest in the first few years over a fixed rate mortgage.   After the ARM adjusts though, the rates generally go up.   If you're lucky then the going interest rates will be low when your rate adjusts and you'll then have lower interest costs.   Another benefit in the ARM is that the principal is decreased a the loan ages, so you have lower interest rate at the start with higher principal but higher interest later when principal decreases.   For this reason I'd rather pay 3% for 15 years and then 5% for 15 than have 4% for 30 years.   I wondered, if you might expect the lower interest rates early in the ARM to make up for the higher interest rates later on. 

I'm going to look at some examples of how ARM mortgages might compare to a fixed rate mortgage over time.   These are just examples based on example ARM mortgages I found.   Different mortgages will have different terms and rates.  I'm also going to make some arbitrary choices about how interest rates might change in the future, but nobody can tell what interest rates will look like 10-30 years from now.  

First I'll look at the worst case scenario assuming that the ARM adjusts to its maximum interest rate and then stays there for the life of the loan.   I doubt this situation will happen because that would be pretty high interest rates for a long period of time, but you never know.   I searched on Amerisave and got some quotes for loans for a $280,000 mortgage and closing costs at about 1% total.   The 30 year fixed rate I'm using is at 4.375%.   The 10 year ARM is 3.75% and the 7 year ARM is 3.25%.    The ARMs adjust to 1 year LIBOR rate + 2.25% with a max of 5% above original rate.   So they will cap at 8.75% for the 10 year and 8.25% for the 7 year.   I figured the running total cumulative amount of interest paid for each loan.   Here is how it looks over the fist 15 years:

Worst Case
I cut it off at 15 years but the trend continues with the ARMs just getting more and more expensive in the last 15 years.

The blue line is the 30 year fixed interest loan.   With that loan you are guaranteed to pay more than the ARMs in interest for the first 10 years.    The 10 year fixed ARM actually puts you ahead of the 30 year fixed for at least 12 years.   Once you get past that the ARMs both end up being more expensive in the long run. 

I also decided to see how the loans would compare if LIBOR fluctuated.   I chose to use historical LIBOR rates from a past 20 year period just as an example situation of real life LIBOR interest rate changes.   Below is what the total interest paid would look like if you held each of the loans for the full 30 years and the LIBOR performed like it did from 1988 to 2008.

As you can see the ARMs in this example still end up with pretty significant costs over the 30 year term compared to the fixed rate loan.  

Now say you got to a point 15 years down the road and your ARM had adjusted.   You could easily be paying something in the realm of 7-8% on your loan at that point.   If you chose to refinance then you could get another ARM and get a rate down to 5.5-6%.   This would put you worse off then compared to the 4.375% rate of today's 30 year fixed.   You might luck out and hit it right so that interest rates are relatively low and then be able to get a ARM with a rate in the 4-5% range.   Lets say you start with one of the ARMs today and then after the rates adjust you refinance into an ARM or fixed term loan to keep your interest rate around 5.5% for the remainder of the 30 years.   THat would look like this : 

Refinance to 5.5%

That doesn't look so bad.   But you're really just taking your chances that the rates will be favorable in the future.   Its quite possible that when your ARM adjusts it will be in the middle of a high interest rate period and you could be stuck paying the max 8% rates for the ARM for a long time.  As you can see in the first graph it doesn't take long to end up paying more with the ARMs if you end up in a high interest environment when it adjusts.

There are two situations that I think an ARM is an OK choice.  If you KNOW that you will only be in the home for a few years then an ARM can be a good choice.   I think few people are really in this kind of situation, but I'm sure some people are.  Another case where ARMs may make sense is if you have sufficient assets to pay off the mortgage if or when necessary. 

In most cases though you will be best going with a fixed rate loan.   This is especially true in todays very low interest rate environment.

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