Forget 30-year fixed rate mortgages—here’s why you’ll save more money with an ARM

Wealth


With mortgage rates reaching historic lows this year, many people are looking to refinance or purchase a home.

But should you do an adjustable rate mortgage (ARM), which has an introductory fixed-rate period — usually five, seven or 10 years — and then periodically adjusts based on market conditions, or the more popular 30-year fixed-rate mortgage?

Most experts will tell you it’s safer to go with the latter. However, after taking out several types of mortgages over the past 17 years, here’s why I’m convinced that an ARM will likely save you more money:

1. The long-term interest rate is on a downward trend.

There’s certainly value in knowing that your interest rate will never go up over a 30-year period.

But the yield on the benchmark 10-year Treasury note is a key barometer for mortgage rates; when bond prices drop, interest rates rise. And bond yields have been declining since 1981.

It’s very unlikely that the downward trend will change any time soon. In order for that to happen, investors would have to feel more optimistic about the economy (since quicker growth can lead to inflation, which then erodes the purchasing power of fixed-rate bonds and puts pressure on the Federal Reserve to raise interest rates).

Therefore, choosing an ARM is smarter because you’d be paying a lower interest rate (during the fixed-rate period) than a 30-year fixed-rate mortgage. And when the ARM eventually floats, you can expect interest rates to still remain low.

2. It’s a better match for the average length of homeownership.

Too many people overestimate how long they’re going to live in — and own — the same home. Given that the average homeownership tenure is 8.5 years, it makes no sense to do a 30-year fixed rate.

The more efficient route would be to do an ARM that matches a reasonable homeownership period. For example, if you plan to live in your house for eight to 10 years, taking out a 10/1 ARM (where the introductory rate lasts 10 years) is more cost-effective.

A 10/1 ARM is usually between 0.25% to 0.5% less expensive than a 30-year fixed-rate mortgage. Why? Because rates are lower when you borrow for a shorter period of time.

10/ARM vs. 30-Year Fixed Mortgage

Sam Dogen, Financial Samurai

To illustrate, let’s compare a 10/1 ARM with a 2.5% interest rate versus a 30-year fixed mortgage with a 3% interest rate.

With the 10/1 ARM, the borrower’s monthly payment is $133 less, and after 10 years, the balance declines by 26% ($7,398 less). If the mortgage isn’t paid off — or if the house isn’t sold — by the 10th year, the owner can either refinance for a balance lower than 26% or let the ARM float.

3. There’s usually a cap on how much the rate can adjust upward.

One of the biggest fears perpetuated by proponents of the 30-year fixed mortgage is that once a fixed-rate period is over, the interest rate will shoot higher — making monthly payments unaffordable.

This simply isn’t true because ARMs typically include several kinds of caps that control how much your interest rate can change at the end of each adjustment period. So unless your lender is trying to swindle you, there are no “endless” interest rate increases.

In 2014, for example, I got a 5/1 ARM with a 2.5% interest rate. In 2019, the highest it could reset to was 4.5% for one year. The ARM could reset by another 2% in 2020, all the way up to a maximum of 7.5%.

But of course, instead of allowing the ARM to reset, I refinanced my mortgage to a 7/1 ARM with a 2.6% interest rate, with no fees.

4. You’ll be more disciplined.

Think of an ARM as a money coach who pushes you stay on top of your finances.

Since you have a shorter timeline to reduce debt, you’ll be more motivated to pay extra principal every month, quarter or year. The goal is lower your balance by as much as possible before your introductory fixed-rate period is over.

A 30-year fixed mortgage, on the other hand, is like your neighborhood gym: You hardly ever go, even though you know you should. When you have three decades to pay off debt, the natural tendency is to sit back and take your time.

5. Higher rates aren’t necessarily a bad thing.

6. You have the ability to take action.

Choose your mortgage wisely



Source link

Products You May Like

Articles You May Like

Gap (GPS) reports Q4 2020 earnings, 2021 sales outlook
Saks Fifth Avenue owner spins e-commerce site into separate business
Rocket Mortgage founder Dan Gilbert made $30 billion on paper after stock’s surge
Leon Cooperman calls Sen. Elizabeth Warren’s wealth tax ‘foolish’
‘I love bitcoin’ as a replacement for gold

Leave a Reply

Your email address will not be published. Required fields are marked *