I noticed that mortgage rates are going up. I am interested in a 30-year mortgage. Should I take a fixed rate loan or an adjustable rate mortgage?
Thank you for your question about choosing a fixed rate or adjustable rate mortgage. As 30-year Fixed Rate Mortgage (FRM) rates rise, many borrowers are looking into Adjustable Rate Mortgages (ARM) as a cheaper alternative.
If you are shopping around for a mortgage, an adjustable rate mortgage might look attractive. With mortgage rates rising, it is important to compare the pros and cons of a Fixed Rate Mortgage vs. an Adjustable Rate Mortgage.
In order to help you choose the right loan, start by learning more about:
The rate on a 30-year Fixed Rate Mortgage rose significantly in the past year, whereas the 5/1 ARM rate rose less.
According to Freddie Mac's Primary Mortgage Market Survey, average mortgage rates changed between January 1, 2014 and March 27, 2014 as follows:
The Chart below shows the change in average monthly rates for 5/1 ARM and 30-year FRM for the period of January 2013 – February 2014. (The rates are average, national rates based on the Freddie Mac PMMS):
With a far lower interest rate, a 5/1 ARM offers a substantial savings, at least for the first 5-year period.
Here is an example for 30-year loan for $200,000 loan based on market rates for the end of March 2014. Here are three benefits of an ARM loan – for the first five years:
The chart below summarizes your monthly payments for the first five years:
|Your monthly payments and Interest||5/1 ARM||30-yr FRM|
|Initial Interest Rate||3.10%||4.40%|
|Initial Monthly Payment||$854||$1,002|
|Total Interest Paid for First 5 Years||$29,377||$42,129|
|Balance After 5 Years||$178,135||$182,038|
As shown above, the short-term gains of an ARM are beneficial. However, before you take an ARM, you need to weigh your short-term savings against the potential risks of higher rates and higher payments down the road.
An ARM carries the risk of higher payments when your interest rate adjusts. The first adjustment on a 5/1 AMR is after after 5 years. Since you don’t know the exact amount of time you will hold on to your home/mortgage, or what future mortgage interests will be, you might find yourself with:
The most obvious risk in taking a ARM is that after the initial period is over (after 5 years on a 5/1 ARM), then the monthly payment will increase. If your payment increases, will you be able to afford it?
The chart below shows your potential saving/losses comparing a $200,000, 30-year fixed rate loan at 4.4% compared to an adjustable rate loan with a starting rate of 3.1%, an annual cap of 1%, and a lifetime cap of 8%.
In a "worst-case"scenario:
If you were to choose the FRM at 4.4%, then your payment would always be $1,002. The following table shows your interest rate and monthly payments the 5/1 ARM, under the "worst-case" scenario:
|Months||ARM rate||ARM payment|
|1 - 60||3.10%||$854|
|61 - 72||4.20%||$950|
|73 - 84||5.30%||$1,048|
|85 - 96||6.40%||$1,148|
|97 - 108||7.50%||$1,249|
|109 - 360||8.00%||$1,341|
Bills Action Plan
An ARM loan offers many advantages, including a lower monthly payment and a potential savings on your finance costs. However, it also carries long-term risks, depending on the movement of interest rates.
Before you take an ARM make sure that you: