When exploring loan options with new clients, a common statement I hear from them is, “I don’t want an ARM (Adjustable Rate Mortgage) or interest-only loan.” In turn, the question I ask is, “how long do you plan to keep this mortgage or stay in this home?” Although today’s historically low, 30-year fixed rates offer cheap insurance over the long run, those buying for the shorter term will likely have overpaid for peace of mind. Remember that security comes at a cost: at 5.0%, the interest payments on a $500,000 30-year mortgage are roughly 93%, or $466,278!
Following the housing market’s recent setbacks and years of press lambasting “bad, interest-only mortgages,” there is now a general presumption that these mortgages were somehow designed to foster ruin. My own observation is that different mortgages serve different needs and that problems naturally arise when a mortgage is improperly paired with a borrower’s qualifications and expectations.
To determine which mortgage best suits your needs you should ask yourself how long you intend to keep the mortgage (i.e. not refinancing to pull cash out for home improvements, college funds, etc.) or to keep the house. This is always a tough call, but given current interest rates, if there’s even a fair chance you would be holding onto the mortgage for at least 8 to 10 years, then a 30-year fixed is worth strong consideration. If, however, the odds favor a shorter period, then an adjustable mortgage might be your best option. The reasoning behind this lies in how the amortization schedule works.
The average lifespan of a 30-year fixed mortgage is around 7 to 8 years. This figure may have increased to roughly 10 years as current holders of record-low rates will be reluctant to give up their prize mortgages through refinance or sale. Investors are aware of these trends and the rate extended for 30-year fixed mortgages is partly determined by how much interest the investor is likely to make within this time frame. Keep in mind that the amortizing schedule carries forward-weighted interest payments. Staying with the example of a $500,000 mortgage at 5.0% with payments of around $2684 per month, after 5 years the borrower would own $40,856 more of their home’s equity through principal balance reduction and the investor would have collected $120,190 in interest from total payments of $161,046. So, after 5 years, you still owe $459,144.
With shorter term Adjustable Rate Mortgages, the investor does not have to guarantee a rate over an extended 30-year period, so there is more competition and rates tend to be significantly lower. With today’s low rates, a 5-year fixed ARM could have a rate as low as 3.5%. Compared to the above 30-year fixed, monthly payments would be $2245 ($439 less) and after 5 years you would own $51,514 of equity ($10,659 more), have paid $83,199 of interest ($36,991 less), for total payments of $134,713 ($26,332 less). If you need a mortgage for 5 years, this option is the clear winner, allowing for greater principal reduction with far lower payments.
Interest-only ARMs tend to carry rates slightly higher than regular amortizing ARMs. A 5-year interest-only ARM’s rate might be around .375% higher than the above example (3.875%) however payments are limited to just interest and are therefore significantly lower. A $500,000 interest-only mortgage fixed at 3.875% would have monthly payments of around $1615 and you would pay just $96,875 over 5 years to service the loan. This might be a good option for a borrower less interested in gaining equity in their home than in freeing up money for their business or other investments.
So determining which loan is “best” depends on timeline and no one has the perfect crystal ball telling them how long they’ll remain in a home or keep their mortgage. As long as you are comfortable with the higher fixed payment and are likely to keep the mortgage for the foreseeable future, a 30-year fixed may be your best bet. On the other hand, if there is a fair chance that you’ll be parting with your loan after a few years, then avoid the knee-jerk assumption that adjustable or interest- only mortgages are bad. If circumstances warrant, they could save you a lot of money.
Nicholas Ballard is both a mortgage broker and banker specialized in the residential Marin market. For assistance, please call or e-mail:
Nicholas Ballard: 415-526-1941; firstname.lastname@example.org
Real Estate Financing
CA Dept. of Real Estate #01356374
California Mortgage Advisors, Inc.
CA Dept. of Real Estate #01170868
Redwood Highway, San Rafael 94903