One of the biggest, if not the biggest, purchase most people will ever make is buying a house. Most of us don’t just have several hundred thousand saved up to purchase a home with cash. To assist in that home purchase you will most likely have to get a mortgage to help purchase your home. A vast majority of people will choose a 30 year fixed mortgage because they feel it is the safest choice. I think more people should ask themselves between a fixed or adjustable rate mortgage, which one is right for you?
The long established rule is that you should save a 20% down payment to buy your house, although the fact is most people put down far less than that. I think there are a number for reasons down payments are lower now than they were 30 years ago:
- higher home prices
- people can’t manage their money to save
- there are alternatives that allow you to skip private mortgage insurance (PMI) with less than 20% down anyway.
Most people also choose by default the 30 year fixed because that’s what everyone recommends.
Why is there a 20% down “rule” anyway?
This is a bit of a side bar from this topic, but still very relevant. Most mortgages you get from a bank are sold to the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) which are Government Sponsored Enterprises.
Congress created these companies to provide liquidity in the mortgage market. Fannie Mae and Freddie Mac buy and repackage similar mortgages into Mortgage Backed Securities (MBS) and sell them in the market just like stocks, bonds and mutual funds. Even though the banks sell the mortgages to Fannie Mae and Freddie Mac, the banks still retain some liability for the mortgages they sell.
Private Mortgage Insurance protects the bank if you default on your payments. If you had put 20% down and missed your payments and the bank had to foreclose, they could still probably sell your house and not loose any money. However, if you only put down 10%, depending on what happened in the housing market, the bank might have to sell your house at a loss.
Adjustable rate mortgages are too risky, right?
Well, not necessarily. Some are riskier than others. A 3/1 adjustable rate mortgage (ARM) is fixed for the first three years or 36 months and then the interest rate adjusts every year thereafter. The new mortgage rate is calculated by adding a margin to an index. As an example the margin might be 2% added to an index such as the three year constant maturity treasury. If the three year constant maturity treasury is 1.5% then your new interest rate (starting in the 37th month) would be 2%+1.5%=3.5%. This is often called a “reset” on your mortgage interest rate.
Do you have an adjustable rate mortgage that is going to “reset” soon and you don’t know what the new interest rate will be? Your bank is required to send you notification in the mail of what the new interest rate will be, but if you’re still a few months away from the reset and want a general idea, you can look up the index that your mortgage is tied to on the US Treasury’s website. You can find what index your mortgage is tied to on your mortgage documents. If I’ve lost you and you need help, leave a comment or shoot me an email, I’m happy to try to help!
Types of Adjustable Rate Mortgages
You can find an adjustable rate mortgage with many different fixed initial periods from one year all the way up to ten years. You’ll usually see them listed on bank websites as 1/1 ARM, 3/1 ARM , 5/1 ARM , 7/1 ARM or 10/1 ARM. They all usually work the same way I described up above like the 3/1 ARM. These are what I like to call the “traditional” ARM options. Banks have been offering these for decades. You can search for the best interest rates
How high can your interest rate go? Well there are rules that are outlined before you take out the mortgage. Usually the rules are 2%/2%/5% or 5%/2%/5%. So what does that mean?! The interest rate can increase (or decrease) up to 2% at the first reset and 2% each year after that up to a lifetime maximum of 5% or up to 5% at the first reset and up to 2% each year after that up to a lifetime maximum of 5%. Here is an example of what it looks like on the DCU.org website:
But wait, there are other adjustable rate mortgages too! Credit Unions are usually more creative when it comes to offering different mortgage products. A more popular option to emerge in the past ten years is the 5/5 ARM. This means the interest rate is fixed for the first five years, then it adjusts or resets and is fixed again for another five years. This option has less risk than a 5/1 ARM. There are some other options out there too:
- 2/2 ARM
- 3/5 ARM
- 10/10 ARM
- 15/15 ARM.
- There are probably even more options that I haven’t seen yet!
So where can you find these “alternative” adjustable rate mortgages? Check with some of your local credit unions since they might offer these products. Also there are a few larger credit unions that offer these ARMs as well:
- Navy Federal Credit Union (need military affiliation)
- Pentagon Federal Credit Union (military affiliation or join certain organizations in order to join)
- Digital Federal Credit Union (I think anyone can join)
You could save thousands with a adjustable rate mortgage!
On average, most people do not stay in their homes for longer than 10 years. This article says the average was about 8 years in late 2016. Why would you lock into an interest rate for 30 years if you might only stay in your house for 10 years or less? Banks charge more to lock in a rate for 30 years than 10 years or less.
Lets take a look at what the savings (and risks) are to getting an adjustable rate mortgage versus a 30 year fixed mortgage. I’m not going to lie, I think you should really consider an adjustable rate mortgage, but I want to make sure you know the risks as well! (we have a 7/1 ARM, so I am practicing what I preach)
I’m going to use the rates from DCU as of the date I’m writing this for my comparisons. I’m going to use a $400,000 house with 20% ($80,000) down to run the numbers. The mortgage would then be $320,000.
- The 30 year fixed interest rate is 4.0% and would result in a monthly payment of $1,528
- The 5/1 ARM interest rate is 2.75% and would result in an initial monthly payment of $1,306 ($222 less than the 30 year fixed)
- The 5/5 ARM interest rate is 3.0% and would result in an initial monthly payment of $1,349 ($179 less than the 30 year fixed)
- The 7/1 ARM interest rate is also 3.0% and would result in an initial monthly payment of $1,349 ($179 less than the 30 year fixed)
- The 10/1 ARM interest rate is 3.375% and would result in an initial monthly payment of $1,415 ($113 less than the 30 year fixed)
When comparing the different options you want to consider three things: mortgage loan balance, total interest payments and total payments. Its best to look at these factors over 5, 7 and 10 year periods. Lets look at the first 5 years:
What is this showing us?
Over the first five years of the mortgage, you’d save $13,281 in mortgage payments if you chose the 5/1 ARM over the 30 year fixed. Thats not cash you can just find in the couch cushions! The total interest you pay over those first five years is about $19,527 less. Your mortgage balance would be $6,245 lower with the 5/1 ARM compared to the 30 year fixed. You can see the 5/5 ARM, 7/1 ARM and 10/1 ARM also provide savings compared to the 30 year fixed, but just less savings compared to the 5/1 ARM.
What if we go out to the end of year 7?
When we expand out to year 7, a few things have changed. First, you’ll see the mortgage payments for the 5/1 ARM and 5/5 ARM in red. This is because the interest rate changed and the mortgage payment increased. I assumed the worst case scenario and highest possible interest rate allowed by the mortgage in this comparison. What this means is that if the index the mortgage was tied to doesn’t go up as high, then the new interest rate and mortgage payment might not be as high. Looking at the chart now the 7/1 ARM is now the best option. You’d save $15,002 in mortgage payments, $21,649 in interest and have a $14,974 lower mortgage balance compared to the 30 year fixed. Thats some serious money!
Lets look at a 10 year comparison
In this view over 10 years, again I’ve assumed the mortgage payments highlighted in red are the worst case scenario. The 10/1 ARM is now the “winner” and saves you over $13k in mortgage payments, over $19k less in interest and a $5k lower mortgage balance. If the index for the 5/1, 5/5 and 7/1 ARM doesn’t go as high as I’ve assumed in this comparison, then those options could look favorable too. Keep in mind on the 5/1 ARM you probably would not have kept it past year 5 or 6, but I assumed for this analysis you did.
I’m not a gambler by any means. I’d rather take the known savings over a 7 or 10 year period with a 7/1 ARM or 10/1 ARM and deal with possibly having to refinance in 7 to 10 years. Thats a long time and a lot can happen. Could interest rates be higher if I go to refinance, yes absolutely. I feel better knowing I will save over $10k. We have a 7/1 ARM on our current house and had a 5/5 ARM and 30 year fixed on our two previous homes.
These numbers will look different for every person’s scenario. I’m happy to share the spreadsheet with all the amortization schedules and calculations for anyone who wants to use it. Just shoot me an email or leave a comment below.