Adjustable-rate mortgages (ARMs) get a bad rap. Some worry that they're super risky for the borrower. Others contend that ARMs ultimately end in disaster due to the prevalence of exotic adjustable-rate mortgages leading up to the financial crisis.
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One of the most common types of adjustable rate mortgages, the 5/1 ARM, features a fixed rate for 5 years, after which the rate resets once per year up or down based on the level of interest rates. Although many people simply dismiss their utility, I can think of three reasons why an ARM may be better than a fixed-rate mortgage.
1. Lower rates help you build equity faster
The obvious advantage of an adjustable-rate mortgage is that they carry lower interest rates during the fixed period of the loan. At the time of writing, the lowest rate advertised on a major mortgage site for a 5/1 ARM was about 3.2% compared to a rate of 3.9% for a 30-year fixed loan.
While the difference amounts to a mere 0.70 percentage points, it can make a big difference in your payment. The 30-year fixed mortgage carries a monthly payment of $943 per month, while the ARM carries a payment of about $865.
The smart thing to do might be to take out a 5/1 ARM but make monthly payments as if it were a 30-year fixed mortgage. By the end of the 5-year fixed period, the borrower will have made a much larger dent in their balance than the borrower who uses a 30-year fixed mortgage.
Here's the math based on a $200,000 mortgage at current mortgage rates.
Source: Calculations by author.
After five years of equally sized payments, the buyer who used the 5/1 ARM instead of a 30-year mortgage would be more than $7,200 closer to paying off the home in full.
Having more home equity is a powerful buffer should interest rates rise. If, at the end of five years, your rate rises by more than 1 percentage point (from 3.2% to 4.25%), your monthly payment will simply match that of the 30-year fixed-rate mortgage. Of course, the $7,200 in additional home equity you built up is yours to keep.
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2. Rates can go down, too
A fixed-rate mortgage can be psychologically intoxicating. If rates go up, we get to feel like geniuses. If rates go down, we refinance, and feel smart for negotiating a better deal.
In either case, we feel like we win. But really, the biggest winner is the mortgage broker.
It's no wonder so many brokers seem to default to the assumption that locking in your rate is a good idea. The fear of rising rates creates action. "Lock in your rates before they rise" is a better pitch than "come back tomorrow, rates might be lower."
After roughly 40 years of broadly declining interest rates, it's only natural to worry that rates might start creeping higher. And that just might happen. Predicting where interest rates will go from here is impossible, and I won't pretend to have a crystal ball. But what I do know is that at any point in time, 5-year loans have almost always been less expensive than 30-year loans. That's an edge you can count on.
3. Time is on your side
If you don't plan to live in a home for 30 years, why borrow for 30 years to buy it? Borrowing on a 30-year term to finance a home you plan to live in for just five or 10 years is a losing proposition. You'll pay thousands of dollars more in interest, and own less of your home when you sell it.
We can reuse a previous example here, except we'll assume you only make the minimum payment on your mortgage. The table below compares a 5/1 ARM at 3.2% and a 30-year fixed rate mortgage at 3.9%. We'll use a $200,000 loan in each case.
Source: Author calculations.
The difference here is pretty staggering.
The 5/1 ARM will save you about $78 per month on your mortgage, and you'll have about $2,000 of additional home equity when you go to sell your home. All in all, it adds up to over $6,800, an amount I think most people would prefer to have in their pockets than pay to their bankers.
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