As of Dec. 14, 2016, Bankrate.com's lender survey reported that mortgage rates were 4.03% for a 30-year fixed, 3.18% for a 15-year fixed, and 3.3% for the first five years on a 5/1 adjustable rate mortgage (ARM). Whether a fixed-rate mortgage or an ARM is the best choice in today's market depends on your unique situation. First, you should talk to several lenders to find out what you qualify for given your credit score, income, debts, down payment and other factors. It's far more helpful to know what you're actually working with than to choose among options that are purely theoretical. Once you know what you can borrow, how do you choose between a fixed-rate mortgage and an ARM? Consider these factors.
Type of ARM
ARMs come in many types. The most popular is a hybrid ARM, and out of these, the most popular option is the 5/1 ARM, followed by the 3/1, 7/1 and 10/1 ARM. Here’s how hybrid ARMs work: A 5/1 ARM, for example, has a fixed interest rate for the first five years, called the introductory period. After that, the interest rate adjusts once a year for the rest of the loan term (say, 25 more years). There are ARMs that adjust less often than once a year, such as the 3/3 and 5/5 ARM, but these can be hard to come by. The longer the initial period, the smaller the difference will be between the interest rate of the ARM and the interest rate of the fixed-rate mortgage.
In the United States, the interest rate for most ARMs is based on the U.S. Treasury rate, while about 20% of ARMs are based on the London Interbank Offered Rate (LIBOR). Treasury rates are currently very low, so if you take out an ARM now, there’s a good chance your interest rate will increase when the ARM’s introductory period ends.
Our example above assumes a $200,000 mortgage. If you're taking out a smaller mortgage - say, $100,000 - the monthly payment difference between the ARM and the fixed-rate mortgage shrinks to just $68.73. This difference may not be large enough to make you want to take on the additional risks associated with ARMs (which we'll discuss in a moment). It depends on your financial situation, of course, but if $70 a month is a big deal to you, you might want to ask yourself if you will really be able to afford all the expenses associated with home ownership.
If you want to use an ARM because its lower interest rate will help you qualify for financing to purchase a more expensive property, you have to consider whether the difference in the quality of property you can get with the ARM makes the interest-rate risk worthwhile. You're going to be tempted to say, "Yes! Of course!," because of the amazing school district, new hardwood floors, or wonderful neighborhood, but try to envision how you would feel about that property if the monthly payment doubled after a few years.
Risk Tolerance and Future Plans
ARMs are subject to interest-rate risk. After the initial term, the interest rate for this type of mortgage adjusts to reflect current market conditions. What will the ARM's interest rate be when it resets after the introductory period?
The details of a particular ARM—what’s called the interest rate cap structure—tell you just how high your monthly payment could go. For example, a 5/1 ARM might have a cap structure of 2-2-6, meaning that in year six (after the introductory period expires) the interest rate can increase by 2%, in subsequent years the interest rate can increase by an additional 2%, and the total interest rate can never increase by more than 6%. Thus, if your introductory rate was 3.5%, your ARM would never adjust higher than 9.5%.
Whether your rate ever adjusts that high depends on the ARM’s index rate. If your ARM is indexed to the one-year Treasury rate, and that rate is the same in year six as it was in year one, your interest rate will not increase in year six. However, if the Treasury rate has gone up by 3%, your interest rate won’t increase by more than 2% in year six because of the cap.
People who get ARMs often think that one of the following events will occur:
- They will sell the home before the loan resets.
- Their income will increase before the loan resets.
- They'll be able to refinance before the loan resets.
- Interest rates will remain stable or decline, giving them a similar rate to the introductory rate when the loan resets.
If you've been able to fog a mirror during the last several years, you likely are aware that people's expectations and financial reality can differ dramatically. Borrowers who want to take out an ARM under any of these common assumptions should consider whether they would still be able to manage the mortgage if their assumptions don't pan out.
If the ARM appeals to you, but you're concerned about the risks, consider a Federal Housing Administration (FHA) ARM. An FHA ARM is highly regulated, so you should be able to determine exactly what you are getting into. The FHA offers 1-year ARMs and 3-, 5-, 7- and 10-year hybrid ARMs. The interest rate on the 1-year and 3-year versions cannot increase by more than 1% per year after the introductory period or by more than 5% over the life of the loan. The interest rate on the 5-, 7-, and 10-year ARMs cannot increase by more than 2% per year after the introductory period, and the lifetime cap is also higher, at 6%.
Suppose you took out a 5/1 FHA ARM with an interest rate of 4%. For the first five years, your interest rate would be 4%. In year six, it might increase by as much as 2%, depending on the one-year U.S. Treasury rate, so your rate could go as high as 6%. In year seven, your rate could increase by another 2%, to 8%, and in year eight, your rate could again increase by 2%, to 10%. At this point, you would have reached the 6% ceiling; your rate will never go higher than 10%. However, on a $200,000, 30-year mortgage, the difference between 4% interest and 10% interest is a monthly payment of about $955 versus about $1,755. You have to ask yourself if a worst-case scenario of an extra $800 a month for years eight through 30 is something you can live with.
The bad thing about an FHA ARM is that, like all FHA mortgages, it requires borrowers to pay an upfront mortgage insurance premium of 1.75% of the loan amount (which is usually rolled into the loan, and you’ll pay interest on it as a result). It also requires a monthly mortgage insurance premium payment, the cost of which depends on your loan term and down payment. For example, if you make the FHA’s minimum required down payment of 3.5% and take out a 30-year loan, you’ll pay 1.35% of the outstanding loan balance each year in mortgage insurance until you pay the loan in full. This sum is divided by 12 and added to your monthly payment. On a $200,000 loan, the upfront premium would cost you $3,500, and the monthly mortgage insurance premiums would cost you about $225 a month for the first year and gradually decline after that. These costs increase the expense of owning a home in both the short and long term.
Choosing Between a Fixed-Rate Loan and an ARM
Now that you know how ARMs compare to fixed-rate loans, how do you decide which one makes the most sense for your situation?
“Most of our clients fall into the fixed rate bucket. They are traditionally first time homebuyers that are buying a condo or single family home and don’t know their future plans,” says Sean O. McGeehan, a loan officer in Homer Glen, Ill., just outside Chicago. “If they end up having children and need to stay there in the long-term, a fixed rate will give them certainty and stability in their mortgage
payments,” he says.
Since interest rates have almost nowhere to go but up, most homebuyers aren’t interested in taking the risk on an ARM.
“Due to the current low interest rate environment, I’ve been utilizing the 30-year fixed loan option 90% of the time over the past six-plus years for first time homebuyers,” says Lauren Abrams, a mortgage advisor with Absolute Mortgage Banking in San Ramon, Calif.
“However, it is important to have a conversation about the buyer’s long-term plans for the property. In most cases buyers don’t know or can’t predict what those plans will be,” she says. “Clients sometimes insist that this is just a starter home and [they] won’t be in it for more than three to five years.” In her experience, Abrams says, this time frame can actually be as short as one year if there is a divorce, job transfer, marriage or children, but that time frame can also easily extend to 10-plus years.
While a borrower who thinks they will be in the home for a shorter time and wants to use an ARM could sock away the monthly savings in an interest-bearing account to cover a potentially higher payment, if they’re still in the home when the rate adjusts, “in reality, homebuyers typically will not save that money,” Abrams says.
Wealthy clients and investors who have a plan for how long they will carry the mortgage and can afford potentially higher payments, later on, are more likely to see the appeal of an ARM and more likely to benefit from its introductory rate.
Here’s a third option: If you can afford the higher payments on a 15-year fixed rate mortgage and plan to stay in the home a long time, you will save the most money in the long run because the total interest payments are much lower. And locking in today’s near-rock-bottom 15-year rates will almost certainly be less expensive than carrying an ARM long-term, even though the ARM is cheaper now.
The Bottom Line
Only 10% of borrowers these days are choosing ARMs for home purchases according to Freddie Mac's 30th Annual ARM Survey, released in January. If you want to consider joining them, online calculators such as Bankrate's ARM or fixed-rate calculator can perform some of the mathematical calculations that you'll need to make your decision.