Fixed or Variable Rate Mortgage: Which Is Better Right Now?

As of Mar. 28, 2018, Bankrate.com's lender survey reported that mortgage rates were 4.30% for a 30-year fixed, 3.72% for a 15-year fixed, and 4.05% for the first five years on a 5/1 adjustable-rate mortgage (ARM). These are national averages; mortgage rates vary by location and are highly dependent on your credit score.

So the first step in deciding whether a fixed-rate mortgage or an ARM is the best choice in today's market is to talk to several lenders to find out what rate you qualify for and what loan terms make sense for you given your credit score, income, debts, down payment and the monthly payment you can afford.

Once you know what rate and term lenders will extend to you, how do you choose between a fixed-rate mortgage and an ARM? Consider these factors.

Fixed vs. ARM: Monthly Payment Difference

For every $100,000 you borrow, here’s what you’d pay per month for each of the major mortgage types at the national average interest rates listed above:

– 30-year, fixed rate mortgage: $495

– 15-year, fixed rate mortgage: $726

– 5/1 adjustable rate mortgage: $480 for the first 60 months

Looking only at the monthly payment, the adjustable rate mortgage seems like it might be the better choice. It’s the cheapest option by $15 per month. The larger your mortgage, the bigger the monthly savings. If you’re borrowing half a million, you’ll save $73 per month with an adjustable rate.

Is this difference large enough to take on the additional risks associated with an ARM?

Types of Adjustable-Rate Mortgage

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, but 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. The Federal Reserve raised interest rates once in March and is expected to do so two more times in 2018, with each increase being 0.25%.

Risk Tolerance and Future Plans 

When you take out a fixed rate mortgage, you know before you sign your closing papers exactly how much your mortgage payment will be each and every month for as long as you have the mortgage. Many people value this stability.

ARMs are subject to interest-rate risk, or the possibility that the interest rate will change. After the initial term, the interest rate for this type of mortgage adjusts to reflect current market conditions. How do you know what an ARM’s interest rate will 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. A 5/1 ARM, for example, might have a cap structure of 2-2-6, meaning that in year six (after the five-year introductory period expires), the interest rate can increase by 2%, in subsequent years the interest rate can increase by an additional 2% per year, and the total interest rate increase can never total more than 6% over the life of the loan.

If your introductory rate was 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%, making your rate 10%. At this point, you would have reached the 6% ceiling; your rate would never go higher than 10%.

While the cap reduces your risk somewhat, 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.

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 rate that is similar to the introductory rate when the loan resets.

If you lived through the Great Recession, when many borrowers had ARMs they couldn’t afford after the interest rate reset, you know 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, especially if the interest rate increases as high as it can go. If not, a fixed-rate mortgage may be a better choice.

FHA ARMs

The Federal Housing Administration (FHA) guarantees adjustable-rate mortgages, allowing lenders to offer them to borrowers who need more lenient requirements to qualify. 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 6%.

Like all FHA mortgages, while an FHA ARM may have more lenient qualifications, 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. If, for instance, you make the FHA’s minimum required down payment of 3.5% and take out a 30-year loan, you’ll pay 0.85% 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 $142 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 and can make it less affordable.

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?

Sean O. McGeehan, a loan officer in Homer Glen, Ill., just outside Chicago, weighs in this way. “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,” he says. “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.”

Since interest rates have almost nowhere to go but up in today’s market, 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, 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.

Borrowers who think they will be in the home for a shorter time and want to use an ARM could mitigate their risk by socking away the monthly savings in an interest-bearing account to cover a potentially higher future payment, if they’re still in the home when the rate adjusts. But “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.

If you can afford the higher monthly payments on a 15-year fixed rate mortgage and plan to stay in the home a long time, it will save you the most money in the long run because the total interest payments will be much lower. And locking in today’s still-very-low 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

Fewer than 10% of borrowers were choosing ARMs in August 2017, according to data from CoreLogic and Freddie Mac.

If you want to use an ARM because its lower interest rate will help you qualify for financing to purchase a more expensive property, 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 – and whether or not you could still afford it – if the monthly payment doubled after a few years. For most borrowers in this rising interest rate market, a fixed rate is probably more prudent.

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