Financial Fellow

Written by J.P. Wicklein

     Buying a home will require you to make a myriad of decisions.  One of the most significant questions you’ll need to answer is whether to get a fixed rate mortgage or an adjustable rate mortgage (ARM).  The answer to this question generally depends on two factors:  1) What’s the difference in interest rates between the ARM and the fixed rate?  2) How long do you plan to stay in the home you’ll be buying?    

     Let’s assume that you plan on taking out a 30 year mortgage.  If the interest rate for an ARM is the same for a fixed rate mortgage then you should probably go with the fixed rate (assuming interest rates are near historical lows).  If, however, the interest rate on the ARM is less you should ask yourself how long you plan to stay in the home you will be buying.  If you know with a high degree of certainty that you will sell your home before the interest rate on the ARM adjusts, you should consider an ARM.

     The following example compares a $175,000 mortgage on a 5 year ARM at 5.5% to a fixed rate mortgage at 6.0%.  Your monthly payments on the fixed rate mortgage will be $55 a month more than the ARM.  Over 5 years that adds up to a difference of $3,300.  If you sell your home within 5 years of buying it, the ARM will be the better loan to choose.   (It should be noted that although the ARM generates slightly larger principal payments during the fixed period of the loan, these gains largely are offset by the larger interest deduction of the fixed rate mortgage.)

Note:  A 5/2/5 ARM can increase or decrease no more than 2% per rate adjustment period (in this case annually) and never adjust higher or lower than 5% above the original rate when the loan becomes variable.

     The above chart reveals the worst case scenario - the ARM resets after 5 years to 7.5% and again after 6 years to 9.5%.  Under the worst case scenario the ARM will still be the cheaper loan for the first 6 years and 4 months.  After which time the fixed rate loan will become cheaper.  Let’s look at an example using a 10 year ARM.

     The chart below compares a $250,000 mortgage on a 10 Year ARM at 5.75% to a fixed rate mortgage at 6.5%.  In this case, choosing the 10 year ARM will save you $121 per month and $14,500 after 10 years.   The 10 Year ARM will be the cheaper loan for at least the first 13 years and 4 months.  (The chart below assumes the ARM resets at the maximum 2% annually and caps out at 10.75%).   

The bottom line

     Choosing an ARM over a fixed rate mortgage is a calculated risk.  If you stay in your home too long after the ARM resets you could wind up paying more money to your lender than you would have if you chose a fixed rate mortgage.  That said if the difference in interest rates between the two loan types is great enough, choosing an ARM can save you a sizable amount of money. 

Photo by: alexbrn