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:
- Fixed rate vs adjustable rates in today’s market
- Savings that are possible with a 5/1 ARM
- The risks of a 5/1 ARM
Mortgage Rates Going Up – ARM rates at a Slower Rate
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:
- Fixed rates rose more than 1% from (3.34% to 4.4%)
- 5/1 ARM rates rose 0.4% from (2.71% to 3.1%)
- The difference between the two rates has increased. The 5/1 ARM is now 1.3% lower than the fixed, when the difference a year ago was 0.6%.
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):
5/1 ARM vs FRM - Short Term Savings
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:
- Lower monthly payment: $147 less
- Less interest paid: $12,752 over 5 years.
- More principal paid: You will owe $3,903 less on your loan balance.
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.
5/1 ARM vs FRM– Long Term Risks
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:
- Higher payments that you can’t afford.
- Higher interest rates and a turning point where you start losing money compared to the costs of selecting a fixed rate mortgage in the beginning.
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:
- After 6 years you will reach your peak savings at $13,454.
- Your monthly payment will be $1,002 on the fixed rate.
- On the 5/1 ARM, your payment will jump from $854 for the first five years to $1,341 in the 10th year onward. That's an increase of $487 per month!
- Your break-even point will be close to 10 years. The longer you hold on to the loan, the larger your potential losses. After 15-years you would face a loss of about $28,752.
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:
- Understand all the terms of the loan including the initial rate, margin, caps and ceilings.
- Don’t rely on a APR and be careful to examine the lender’s assumptions. If they are showing an adjusted payment based on today’s base rate + margin, then you may be in for a surprise down the road.
- Shop around based on the mortgage fee and rate.
- Weigh how long you plan to stay in the house. If you are staying in the house for 5-years, then a 5/1 ARM (or even a 10/1 ARM) offers good savings.
- Can afford the payments after the initial interest period is over.
- Pay attention to the break-even point.