Fixed vs. Adjustable Rate Mortgages (ARM)

 

If you listen to Clark Howard, he has a solid and staunch opinion. Go fixed at all costs.  I’m a bit more flexible depending on the market and your personal preferences. Your first decision is can you sleep at night knowing that at some point your interest may adjust? If the answer is no, then by all means, pick the fixed rate mortgage. However, if you are open to ARM's they can be a great tool when used correctly.  I will also say that if you are deciding on the ARM simply to be able to afford a more expensive home, STOP. Georgia has one of the highest foreclosure rates in the country, and that is one of the reasons.  ARMs come in many different time periods. Even though they are called Adjustable Rate Mortgages, almost all of them have a period where the interest is fixed. That period can be any of the following: 1, 3, or 6 months, and 1, 3, 5, 7, or 10 years. In a typical interest rate market, the longer they are fixed, the higher the interest rate will be.  Fixed rate mortgage also have different periods. There are 10, 15, 20, and 30 year fixed rates that have decent interest rates. Over the past year, we’ve seen the start of 40 year fixed rate mortgages. In some of the bad credit markets, we’ve even seen mortgages that are calculated on 45 and 50 year terms, but that’s a topic for a different thread.  So, how do you decide between a Fixed Rate Mortgage and an ARM?

 

The first decision is the most important and usually the hardest to answer. How long do you plan on owning the home? Most of the information in my posts will relate to “normal” mortgage markets. We are not currently in a “normal” mortgage market – but that also is a different topic.  My recommendation is to really think through how long you plan on owning the property and getting a mortgage that is fixed for at least 2 years longer. However if you can get a 30 year fixed mortgage for less than a quarter of a percent more than an ARM, go fixed.  Let’s say that you live in the home for 5 years then make the decision to move to a different home, yet you want to keep this home and rent it out. So if your plan was to live in the home for 5 years then move, you may have chosen the ARM that had a rate fixed for 7 years (two years longer than you had planned to be in the home). You’ve now decided that you want to keep the home and rent it out. Two years later, your rate starts to adjust and you try to refinance – at investment property rates. Those rates are significantly higher than rates for your primary home. Had you gone with the 30 year fixed loan, you wouldn’t have to touch it.  I want to make something very clear here. If you buy a home and call it your primary home to get the better interest rate, but you plan to move out in a few months and turn it into a rental – that is not legal. Actually it is mortgage fraud. However, like this example says, if you’ve lived in your home for 5 years and at that point decided to move out but keep it as a rental, that is legal and it is not mortgage fraud. The 5 years listed here is not a magic legal number. But that’s another topic altogether.

 

Back to the Fixed vs. ARM, I am a conservative person, so I always ask my clients to consider the fixed loan. However in a normal market, there may be enough difference between the two to make the ARM’s the smart choice. The perfect choice is that you can afford the 30 year fixed payment, you plan on being in the home no more that 5 years, you choose the ARM that is fixed for 7 years and take the difference in the two payments and you invest it for retirement. Other than that, it is a very individual choice.

 

Here is a funny statistic, Baskin & Robins has 31 flavors of ice cream. Last I heard, 70% of what they sell is vanilla. In the mortgage market, the 30 year fixed loan is the ‘vanilla’ loan.

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