Are you willing to risk your home?
When you buy a home, you will learn that there are two kinds of mortgages: fixed-rate and adjustable-rate.
What’s the difference?
A fixed-rate mortgage gives you an interest rate that never changes. An adjustable-rate mortgage gives you a volatile interest rate: in times of slow economic growth and low inflation, the interest rate will be low; in times of high economic growth and inflation, the interest rate will rise.
Why do some people like adjustable-rate mortgages?
Advocates of adjustable-rate mortgages argue that these give you a shot at getting lower rates than you can ever get with a fixed-rate. In late 2010, when the average fixed-rate mortgage was 4.5 percent, I overheard a guy sitting at the table next to me at a sushi restaurant bragging to his dinner companions about his brand-new, adjustable-rate 3.25 percent mortgage.
It’s true that he’s getting a lower rate than those with fixed-rate mortgages … for now.
You can’t predict the future.
But what’s going to happen in 3 years, 5 years, even 10 years, when interest rates rise and this guy’s 3.25 percent rises to a whopping 6 percent or 7 percent?
Advocates for adjustable-rate mortgages argue two points:
#1: You never know which type of mortgage will end up being cheaper in the end – why not keep open the possibility of a cheaper mortgage?
Of course, that swings both ways. An adjustable-rate mortgage might be cheaper OR more expensive down the road. There’s no way to know. Why take on the added risk and uncertainty?
#2: Paying 7 percent in 10 years — when you owes less on your mortgage — is better than paying 4.5 percent now, when you carry the heaviest loan on your mortgage. In other words, it’s better to owe a low interest rate on a big debt, and a high interest rate on a small debt.
Riiiight. Sounds great in theory. Except for one pesky little point:
Don’t assume that 5 years, 10 years, or 15 years down the road, when mortgage rates rise, you’ll be able to handle the extra payments.
Let’s say you’re paying $700 a month on your mortgage right now.
Four years later, you and your spouse accidentally get pregnant. With twins! Congratulations! Looks like one of you will become a stay-at-home parent.
The following year, your brother gets sick. You take two months’ unpaid leave to care of him.
Then your furnace breaks down. Your engine explodes. A storm blows a heavy tree limb onto your roof.
Gas prices have climbed to $6.50 a gallon. You need eyeglasses. And – guess what? – your mortgage has skyrocketed to $1,200 per month.
Can you afford it? More importantly — can you say, with absolute certainty, that you are SO SURE you’ll be able to afford any mortgage bill, no matter how high it climbs, at any time over the next 30 years?
“If it gets too high, I’ll refinance,” you retort.
In other words, you’ll put your family’s fate in the hands of a mortgage underwriter. Nice plan, dude.
What makes you so sure that you can refinance? What if you accidentally miss a bill, and your credit gets dinged? What if banks institute even-tougher lending policies? What then?
Are you willing to take this incredible gamble … knowing that if you lose this gamble, you’ll lose your home?
Mike - Saving Money Today
I prefer the cost certainty of a fixed rate mortgage too. What’s really a problem is that many people who stretched themselves to the limit just to afford the current interest rate will be in big trouble when interest rates start to rise.
Tom
Interesting insights. I think one major point that is missing is that it matters a great deal what prevailing rates are at the time you buy your house. Certain prevailing rates may make adjustable rate mortgages more appealing. After all, rates will fluctuate every now and then at the end of each term with fixed rate too. On the other hand, I certainly appreciate the fact that you might not want to ‘bet the house on it’.
Just got onto your blog – great stuff here! Thanks!
Alex | Perfecting Dad
Came here from your comment on my site. Awesome, I’ll have to look through more but this post caught my eye.
I’m the opposite of you. I almost always take variable because there is a premium for the fixed rate. I always do the math, and it usually is worth more to take a variable interest rate for three reasons: 1) the lower rate saves lots of interest when the interest portion is high at the beginning of the loan and 2) if it goes up later it has to go way past today’s fixed rate to lose money and 3) years down the road the potential expensive rate will be paid with inflated dollars while the early savings will be paid with present day dollars.
If I can afford the risk I always go variable.
On other thing: I’m from Canada and mortgages here have a term far lower than the amortization period. So if I get a 20 year mortgage, the term or the contract will be 5 years or less after which time I renew or pay it off or switch banks, etc. In the US you probably contract for the life of the mortgage.
Fixed Rate Bonds
I would always go for a fixed rate mortgage, particularly as i don’t really keep up to date on changing trends and also it is easier to plan if you have a set amount to budget for each month, as opposed to an unknown amount. Whether it works out financially best at the end, well, i’ve no way of guessing that!
Michael L. Flores
Adjustable rate mortgages are especially beneficial if you are planning to move in a few years and aren’t concerned about possible interest rates changes (which could happen very well). Moreover, ARMs initially come with lower interest rates than fixed deals, so this should also be taken into consideration when choosing a mortgage loan.
Afford Anything
@Michael — But what if you don’t move in a few years? Or what if you can’t sell the house, and you’re stuck holding onto the house even after you move away, acting as an “accidental landlord” — as many people did after the housing crash of 2008?
If the interest rates skyrocket, you might lose the house. Why not have the peace of mind of knowing exactly what the payment will be? The marginally higher interest rate in the beginning is a cheap insurance.
Romeo Canale
Fixed rate loans are definitely the way to go because your payments will remain the same over the entire them. With adjustable rate mortgages there could be any kind of fluctuations (following the initial few years, when it comes with lower interest rates) that may result in higher mortgage payments.
ARM deals are especially beneficial in a decreasaing interest rate environment.
kerstin
A fixed rate mortgage is great for people who want to take the whole term to pay off their mortgage…but why would anyone want to do that ..to tie yourself to a loan for 25/30 years and be at the mercy of the banks ? Ugh no thanks ! A variable rate mortgage gives you the chance to whack more off your mortgage when the interest rates are low by which time the amount of capital you have in your house should ensure that if you need to refinance your mortgage you can. I took a variable rate mortgage and gave myself 5 years to pay it off…only 10 months to go…then i’m renting it out and going travelling for a couple of years ..ahh bliss!
Kit
The first house we bought we used a 30 year fixed and I refied twice over the years to get even lower rates. This made a lot of sense because I hadn’t entered the financial independence world yet. Now my wife and I are both working make good salaries (but in a HCOL area). We almost went with ARM for our home we are in the process of purchasing. However, the ARM rates were only about 0.5% lower. We ended up buying a house that was much less than we could afford so we figured if we hadn’t gotten the ARM and interests rates were hired after the 3 or 5 or 7 years we would have just paid off the balance. Since the delta in interest rates was so small we figured we’d take the fixed rate instead and leave our options open.
P.S. Just started listening to the podcast and after writing “delta” above it made me think of your conversation with J. Money and that delta was referring to the airline and not change.
James
I’d go with you and agree on having a fixed rate mortgage is the better choice.
Swish
This is a fear mentality.
Variable rate mortgages statistically come out further ahead over any 25 year amortization period in interest rate history. That being said one of my mortgages is a fixed rate locked in at 2.59%. Don’t throw out common sense but to say fixed is always better is wrong as often variable mortgages offer prime -1.00-1.50%. This is a massive savings. On a $300k mortgage that 1% is $3k per year of extra principal repayment or savings. If the gap between variable and fixed is .5% or less it makes sense to go fixed but if it is more than that it requires a serious consideration of the risk of rates increasing that quickly. Central bank typically moves rates .25% at a time.
Where I live we recently have had 5 rate increases in the last two years. My variable went from 2% three years ago to 3.25% today. When I chose variable the quoted fixed rates were over 3%. Now I am at the same place and expect rates will go higher but I had three years of opportunity to make prepayments and take a huge bite out of my mortgage while rates were low. If rates hit 5.75% this year I will come out behind on the five year term if they hold flat two years I am $9k ahead and more if they go down. At that point the term is up for refinance so everyone at 3ish% will be refinancing at the higher rate anyways unless you locked into a 10 year term because you had no plans to move or no need for flexibility.
Last item is the majority of variable rate mortgages have the ability to lock in. Right now my quote to lock in my 3.25% is 3.89%. If it was 3.75% I would give serious consideration to locking it in but until my lender will meet me at .5% gap or less I will leave it variable. It depends on needs and risk tolerance and if you run your life so tight that you cannot handle $400 per month extra plus all the life emergencies hitting at the same time
Cheers,
Tyler Johnson
That’s a good point that an adjustable-rate would add a lot more stress and potential loss of money. I wouldn’t want to have to worry about whether or not my mortgage is going to cost a lot more than I originally thought. I’ll have to make sure that I stick with a fixed-rate mortgage so that I could plan everything out.