Whether your mortgage choice is a conforming, jumbo, conventional or government-backed, not only will you have your choice of interest rate and point combinations as well as the term of the loan but you will also take your pick between a fixed rate loan and a loan with an adjustable rate.
The “fixed vs. adjustable rate mortgage” or ARM discussion has been around for a long time.
In fact, before the introduction of the FHA mortgage product in 1934 and the Fannie Mae loan product in 1938, most loan choices were either very short term in nature and some loan programs even required the homeowners to renegotiate the interest rate on their loan each year. The new rate would be set based upon the current cost of funds.
Fortunately, today borrowers have no need to renegotiate a home loan as the terms of their loan are ironclad in their note. It can’t be changed unless the lender agrees to modify the note or the borrowers refinance the existing mortgage with a new one. Regardless, the ARM vs. fixed debate really is one of the few decisions borrowers have to make.
It seems at first glance that a discussion about an ARM vs. a fixed is fairly straightforward. When rates are low lock in the fixed rate and when rates are high take an ARM. But that may not be the best advice after all. That seems a bit counterintuitive but let’s take a closer look.
ARM Mechanics
To understand why an ARM might be a better choice when rates are low as well as high, let’s first understand how loans can adjust in the first place. ARM adjustments are based upon an index, a margin and rate caps. An index can be pretty much what the lender and the borrower agree to but lenders today mostly use the London Interbank Offered Rate, or LIBOR. The LIBOR rate can change daily and there is a method in which the LIBOR is set. The LIBOR is similar to our own Federal Funds rate which is the rate banks charge each other for overnight lending. This rate is set by the Federal Open Market Committee which meets about every six weeks. The LIBOR however can be a bit more dynamic.
Each business day a collection of British banks are surveyed and asked the rate they charge one another when borrowing and making loans and the result is the average of those responding. It’s a somewhat technical process and probably has little bearing on your particular decision on an ARM vs. fixed mortgage, but it should be pointed out how the index is created. Another common index used for adjustable rate mortgages is the 1-Yr Constant Maturity Treasury index, or 1-Yr CMT. This index is released by the Federal Reserve and is based upon the average yield of bonds, notes and Treasuries and adjusted to a one-year equivalent maturity.
Once the index for the note is selected a margin is assigned. A common margin might be 2.25% and is added to the index to arrive at the proper interest rate. If an adjustable rate mortgage is based upon the LIBOR index and the index today were 1.25% and the margin 2.25% the rate would adjust to 1.25 + 2.25 = 3.50%. The monthly payments would then be based upon this new rate and the remaining mortgage balance until the time for the next adjustment.
But what if the index from one year to the next rose significantly from say 1.25% to 9.00%? This wouldn’t happen in the real world, well it could I guess but we would be in some rather tumultuous times like we’ve never seen before. Yet let’s stick with this example to show how interest rate caps come into play. The lender contacts the borrowers and says, “Hey, your rate is getting ready to adjust and the new index is 9.00%.” Adding the margin of 2.25% to the new 9.00% index means the new rate could jump from 3.50% to 11.25%. Such a dramatic jump in payment could very well likely cause a default due to the higher payments. That’s why lenders apply caps.
A cap is a limit on how much a loan can adjust at each adjustment period. There are three primary caps- how much the rate can change at the first adjustment, subsequent adjustment and over the life of the loan. A common initial cap might be 5.00% over the previous rate and an annual cap of 2.00%. The lifetime cap might also be 5.00% although some loans carry a 6.00% restriction.
As you can easily see, rates on ARMs can move over the course of several years in both directions and interest rates can fall just as easily as they can rise. It all depends upon the index, margin and cap.
A fixed rate has no such mechanics.
Hybrids of ARM vs. Fixed
A hybrid is so-called because it works like a fixed rate for an initial period of time and at the end of that period it turns into an adjustable rate mortgage that can adjust annually. In fact, a hybrid at its core is an ARM but with an initial fixed rate.
These fixed rate periods vary but common fixed rate periods are 3, 5, 7 and 10 years. A hybrid rate is listed as 3/1, 5/1, 7/1 and 10/1 with the first number indicating the number of years the rate is initially fixed before turning into an annual arm and the “1” indicates the rate can adjust once per year.
Adjustable rate mortgages used to be of the 6-month of 1-year nature where the rate can change just after six months or 1 year after the loan is first funded. Yet today lenders most commonly offer a range of hybrid terms.
So why do lenders offer hybrids in the first place? Why make the choice? Because hybrids and adjustable rate loans in general offer a lower rate at the outset when compared to a fixed rate loan. This lower rate is sometimes referred to as a “teaser” rate in an effort to convince a borrower to select an ARM over a fixed.
Do lenders really care which loan you select? Probably not but from an accounting standpoint it might. An accounting principle called “mark to market” means, among other things, lenders must assign values to their outstanding loans. If a bank makes a fixed rate loan at say 3.50% then three years later interest rates for that same mortgage program are 6.50% the lender must write down the difference between an outstanding note and current market rates.
With an adjustable rate, lenders can adjust the cost of funds based upon current market value and as the bank’s cost of funds increases so too the borrowers with an adjustable rate loan. This only applies to lenders who own the mortgage. Other than that, lenders really don’t care what type of loan you take, a fixed or an adjustable.
High vs. Low of ARM vs. Fixed
Now that we have a clear understanding of adjustable rate mortgages, let’s get back to the original question- which is better, an ARM or a fixed?
Well, most financial advisers might tell you that when rates are relatively high you should take an adjustable rate mortgage as the likelihood of interest rates falling is high meaning your monthly payment would fall right along with the index at each adjustment.
Back in 1980 the Federal Funds rate was 20.0%. Compare that today’s rate of 0.50% as of March of this year.
That’s quite a difference, isn’t it?
Fixed rate loans back in the early 1980s the 30 year fixed rate hit a high of 17.60%. Adjustable rate mortgages with their inherent teaser rates offered lower rates than a fixed at the time and borrowers flocked to adjustable rate loans during that period which were closer to 10.00%. That’s still high compared to today’s rates but still much lower than a fixed.
The advice of taking an adjustable rate mortgage when rates are high and a fixed when low seems to make sense, right?
But let’s run some numbers based upon today’s reality and you might very well be surprised.
How Long Do You Keep Your ARM vs. Fixed Loan?
You may have picked up some misinformation about how fixed mortgage rates are set and still till this day you might hear that lenders set their mortgage rates based upon the 10-Yr Treasury. It’s a common misunderstanding but one that is really hard to put to rest. The fact is that lenders set their rates on a mortgage bond and not a 10 year Treasury. For instance, for a conforming, 30 year fixed rate loan the index for that rate is currently the FNMA 3.0 coupon. This is a bond that is bought and sold throughout the day by institutional investors and why mortgage rates can fluctuate from day to day.
The reason why some say that rates are tied to the 10 year Treasury might be the fact the maturities on a 10-year and an average mortgage rate are about the same. This means homeowners sell or otherwise retire an existing mortgage around 10 years, closely resembling the maturity on the 10-year Treasury. That might generally be true in some cases but how long someone keeps a home depends upon multiple factors such as current mortgage rates or the housing market. Geographic factors apply as well.
According to the National Association of Realtors the median time frame over the past 20 years shows owners stayed in their homes for approximately seven years although nationally that figure has recently risen as home sales for a period declined due to valuation issues. Sellers couldn’t sell because they were “underwater” on their mortgages. Here in southern California however, the figure is closer to five years.
When interest rates stay in a relative tight range for an extended period of time, like we are now, refinance activity ultimately slows as borrowers who could refinance to lower rates already have.
ARM vs. Fixed: The Five Year Plan
Now let’s talk about hybrids and specifically a 5/1 hybrid as an example. Remember, hybrids are offered in 3/1, 5/1, 7/1 and 10/1 options. One of the first things a loan officer might ask you is how long you intend to keep the property and thus the mortgage. If it’s for a short term, say five to seven years, the loan officer would present the 5/1 and 7/1 options to you.
A similar 30 year fixed rate loan will be somewhere around .375% and .625% lower than its 30-year cousin. Let’s now look at a principal and interest payment on a loan amount of $900,000 using a 30 year fixed rate of 4.00% and a 5/1 at 3.375% amortized over 30 years.
- Fixed Rate $4,296
- 5/1 Hybrid $4,104
That’s a spread of $192 every month. If we do a little more math here we see that over the first five years of the loan that’s a savings of $11,520. A 30 year fixed rate program has an inherent advantage regarding stability. A fixed rate is a fixed rate, there’s not much excitement there but that’s probably the point. Fixed rate loans will have a higher rate compared to the early years of an ARM or a hybrid but that extra amount might be looked at as an insurance policy just in case the property owner changes direction and decides to keep the home for the long haul after all.
But in southern California, most homeowners don’t keep a home or a loan that goes with it for more than five years anyway so that makes a 5/1 or a 7/1 an attractive option. Yes, rates are low right now and it may be considered a prudent move to stick with a fixed but in reality taking an ARM and using the monthly savings for other purposes can only add to the overall wealth of the borrower.
ARM vs. Fixed: Amortization Terms
Banks also have a special affinity for a fixed rate product especially in light of how soon the home owner actually keeps the property. Banks offer fixed rate terms in 10, 15, 20, 25 and 30 years. Let’s look at what the principal and interest payments would approximately be again using that same $900,000 loan amount.
| Years | Term |
|---|---|
| 10 | $8,535 |
| 15 | $6,107 |
| 20 | $5,104 |
| 25 | $4,505 |
| 30 | $4,041 |
This is the principal and interest payment which will not change over the life of the loan. Now let’s say the owner sells the property in exactly five years and look at how much interest was paid to the lender and what the remaining principal balance will be after those five years.
| Years | Interest Paid | Loan Balance |
|---|---|---|
| 10 | $91,586 | $479,456 |
| 15 | $106,589 | $640,135 |
| 20 | $132,766 | $726,481 |
| 25 | $149,486 | $774,643 |
| 30 | $149,756 | $807,273 |
There’s a dramatic difference based upon a loan’s term. After five years into the 10-year note the remaining balance is less than half the original amount at $479,456. All the way down to the thirty year you notice there is $58,170 more in interest paid to the bank and the loan balance has barely nudged sitting at $807,273.
Banks love the 30-year loan for two obvious reasons. The advantage is obviously the lower payment but there is a downside to a longer term. Locking in a 30 year fixed rate loan with the likelihood of selling or otherwise disposing of the property around five years means the bank gets much more interest and is still due a sizable amount of the original loan.
But now let’s take somewhat of a contrarian view on rates and compare the impact of a 30 year fixed rate loan with a 10/1 hybrid.
30 Year Fixed vs. 10/1 Hybrid
Okay, now have an open mind, especially if you’ve heard most of your adult life that when rates are low, like they are now, the wise choice is the 30 year fixed rate loan. Lowest payment and the rate will never change.
Let’s look at a home listed at $1,300,000 and the borrowers are putting 20% down for a loan amount of $1,040,000. We’ll compare a 30 year fixed rate at 3.875% and a 10/1 hybrid ARM at 3.375%.
Sales Price $1,300,000
Down Pymt $ 260,000 (20%)
Loan Amt $1,040,000
30 Year Fixed 10/1 ARM
Interest Rate 3.875% 3.375%
Payment $4,890 $4,597
Balance after…
After 5 Years $938,742 $930,833
After 7 Years $892,426 $881,748
After 10 Year $815,874 $801,629
Note how close the balances are at each juncture even though the interest rate is different by a .50% margin. The monthly difference in interest paid between 3.875% and 3.375% in this example is $293 per month. Let’s look at the amount of interest saved during those same time frames.
Interest Saved…
After 5 Years $17,580
After 7 Years $24,612
After 10 Years $35,160
Now let’s look at what we can do with that $293 monthly savings and a mutual fund that would pay out on average 3.50% each year for and add that yield to the savings over time.
5 Years $22,198
7 Years $27,659
10 Years $39,778
And one more look. This time we’ll take the monthly savings and use that amount to pay it all directly toward the principal balance. Remember that adjustable rate mortgage loans calculate the monthly payment based upon the current interest rate and the outstanding principal. By paying down the principal with the monthly savings the impact is even greater. Here is the monthly savings used when paying down the outstanding loan amount.
After 5 Years $25,469
After 7 Years $35,262
After 10 Years $49,365
Should You Do ARM vs. Fixed ?
These are real numbers and the savings are true. Yes, the 10/1 hybrid ARM will adjust after year 10 and turn into an adjustable rate mortgage that changes annually and there is some inherent risk in that because no one knows what rates will be 10 years from now. No one really knows what rates will be one year for that matter.
However, when considering a hybrid mortgage there is some strategy behind that choice and it begins when the loan officer asks, “How long do you intend to own the property?” and if the answer is, “Well, I guess until I die” or something similar then a hybrid might not be your best choice. Still however, the monthly savings accrued over the years could very well offset any uncertainties in the future and at minimum if rates were extremely high 10 years from now then a refinance is always an option.
If you’re like most homeowners here in Southern California this strategy should take some serious consideration. We mentioned earlier that most homeowners either refinance or sell their homes around five years and the 5/1 and 7/1 makes sense. Even over the longer term the 10/1 provides some real benefit.
The mental adjustment of some while rates are low is to lock in the low fixed rate and forget about it. Take the loan, make the payments and not worry about what rates might do in the future or if housing plans do in fact change.
Let us take your scenario, either for a refinance or a loan used for a purchase, to compare these hybrid options with prevailing fixed rate loans. All you need to do is supply us with the basics such as sales price or appraised value along with the amount you intend to borrow. For jumbo properties in Southern California this is a very successful strategy. Let us prepare a custom spreadsheet showing you how much you can really save choosing an adjustable rate loan over a fixed rate product. We think you’ll be pleasantly surprised.
