As you know, I’m a big proponent of buying real estate right now. And after you’ve secured your property, one of the first things to consider is what type of mortgage you should get. There are all different types of loans and terms you can get, but fixed mortgages, followed by Adjustable Rate Mortgages(ARM), are generally the two most common.
When I bought my first property, I locked in a 30 year fixed mortgage at 5.25%. Since then, I have refinanced to a 7/1 ARM and then refinanced again! My current rate now stands at 3.125% for a 7/1 ARM. With housing prices and interest rates so low, even if I were to move out, I would have a very favorable rent spread. Meanwhile, I’m able to build equity and get a small tax savings from the interest deduction.
Although every situation is unique, I think there are some general principles that apply to everyone depending on what stage they’re at in their life. A fixed mortgage might make sense for some, but an ARM will give you the lowest payments and provide some added perks we’ll see below.
Fixed Mortgage
The most traditional mortgage is a 30 year fixed mortgage, where your payment stays the same for the life of the loan. The rate you lock in at will be your rate until you pay off the loan. The shorter term you select(ie 15 years), the more favorable your interest rate will be. You’ll be adding more equity to your house, but your monthly payment will be significantly higher.
This is generally the most conservative or safest approach. It gives you peace of mind knowing that your payment will never go up for the life of the loan. Unfortunately, this is really the only benefit of a fixed mortgage. A lot of first time homebuyers choose this approach when in fact, they should be doing the opposite. This was one of the first mistakes I made in real estate 🙂
I think a fixed rate mortgage makes sense for older investors(think 30’s, 40’s) when interest rates are low(like right now!). Right now is a great time to lock in a low fixed interest rate if you know your family size, have a stable career(s), and can see yourself living in the same place for 20+ years. I wouldn’t lock in a 30 year fixed, but a 20 year fixed can definitely make sense for some people in today’s current interest environment. If interest rates were to rise though, I don’t think fixed rates are good for anyone. Why would you ever want to lock a rate when interest rates are high?
Adjustable Rate Mortgage
An ARM is attractive to many buyers because it gives you the lowest interest rate and monthly payments. Even in an already low interest rate environment, why pay more than you have to? The average length of home ownership is seven years, so why not match your rate with your intended stay? If you plan on living in the house for only 5 years before upgrading, get a 5 year ARM.
Many people think that there are no caps on ARM’s, but that couldn’t be more false. On your HUD-1 closing statement, there will be very clear documentation that explicitly lays out the maximum rate your loan can ever adjust to. Typically, the adjustment amount is 5%. So if your loan is at 3%, you will never pay higher than 8%. Generally, interest rates are a reflection of inflation and if the economy is booming, interest rates are rising, I know the value of my property will also be appreciating. If my property goes up by 5%, and I have a LTV of 80%, I’m getting a 25% cash on cash return!
One of my favorite benefits of an ARM is the ability to refinance. I love to refinance, and I don’t want to pay one cent to do it. In fact, with my latest refinance(Amerisave review is coming next week), I actually made $300 that was credited to my escrow prepayments. ARM’s allow you to no cost refinance as often as you’d like. As long as you have good credit(740+), and a LTV of 80% or lower, you don’t need to worry about rates dropping. Two years ago, how many people do you think predicted that interest rates would continue to decline? Nobody!
So What Makes Sense for Who?
In today’s low interest environment, fixed rates can make a lot of sense for older investors who want to lock in a low rate. If you’re able to lock in a low rate, rent out your property for 10% cash on cash, who cares if interest rates go down another percent or two? A lot of retirees who have a fixed income stream would benefit from a fixed mortgage because they know exactly what their monthly payment will be and for how long.
I don’t recommend, nor do I believe that most people’s first real estate purchase will be their life long home. Generally, young couples buy a small condo or small house and as their family size increases, they upgrade to a more permanent place. Since purchasing my first condo, I’ve learned a lot about what I like/dislike in a property that will help me when I buy my next home.
As always, with increased risk, their is increased return. ARM’s provide some benefits that conventional fixed loans couldn’t dream of and as a young investor, I’m happy to take on this risk. I know that I’ll save money every month for the next seven years and I’ll be able to no cost refinance whenever rates drop. As we’ve seen, there’s no guarantee that rates will go up 🙂
What do you think about an ARM vs. Fixed Mortgage? Would you rather have the security of a low fixed rate or do you like the idea of a lower monthly payment?
Track All Your Accounts With Personal Capital
Personal Capital lets you see all of your accounts in one convenient place. Sign up now for free.-Harry @ PF Pro
We must bend down to learn everything we can about money and it workings.I have seen several people especially young people mortgage their financial destinies simply because of the lack of understanding on how the mortgage symtem works
I can’t tell if you’re for ARM’s or fixed 🙂 but I agree that a little bit of preparation now can save you a lot of money later on in life.
Good insight. However, I would opt for the fixed rate mortgage and lock in the low interest rates of today. The ARM seems to risky for me — even if I were planning to move in 5-7 years. At that point the rates could be a lot higher than they are now. If the rate were to jump from 3% to 8% that would make a huge difference in total mortgage payments (greater than 50% increase for a $250k loan). I would also caution against perceiving the home as an investment.
If you were going to move in 5-7 years, then I think an ARM would be perfect for you! Most people use equity from their first house to pay the down payment on their next home, so there’s no point in paying more than you have to.
I am actually for ARM though it seem risky if we learn how it works we wont have much problems with it
I agree, there is obviously more risk to an ARM, hence the lower rate. And I think the younger you are, the more suitable an ARM is.
As a young single person with a high income, I’m a huge fan of the ARM. It gives me the benefit of the lowest rates while still having the 30-year amortization and makes it flexible enough for me to pay it off quickly.
I know you probably think I’m crazy for paying it off quickly, but I am looking forward to the security that that will provide me.
Yes, I’m glad I’ve found at least one other young professional who agrees with me on this(and this guy)! Why pay more than you have to?
Have you looked into no cost refi yet? Haha, I know you just bought your place but the rates keep going down 🙂
A few points in favor of the fixed rate just to present a different perspective. I am a young person and still preferred a fixed rate in my recent refi even fully intending to move within the next 5 years because my condo is in a prime rental location. With mortgage rates as low as they are right now, there is a good chance I could rent to break even or perhaps even make a small profit if I elect to keep my condo and rent it out in the future. Another pro in favor of the long term fixed rate is if you can find an assignable mortgage. These are pretty non-existent right now but if you can find one it would be a huge perk to another buyer in 5 years if rates have gone back up.
Totally agree ARMs are definitely a great option for younger people starting out in one house and intending to move in a few years and I actually started out with a 10/1 ARM when rates were higher. Now that they’ve fallen so much and my payment has gone down by $400 though the rental option became more profitable and I decided to lock down the lower rate for a longer term. Just a few other points to consider for different circumstances.
Yes my argument in favor of ARM’s is definitely weakened by this ultra-low interest rate environment and I think in the example you provided, a fixed loan makes sense.
I would consider myself a risky investor, so I don’t mind locking in the lowest rate now and seeing what happens in 5 or 7 years. 2 years ago, people said rates couldn’t go any lower. 1 year ago people said rates couldn’t go any lower. Today, people say rates can’t go any lower Who knows where rates will be at in 5 years? 🙂
Great article as usual. Tell me, what do you think about the home price rises in most of the U.S. in May so far?
Thanks Austin. The general trend so far this year has obviously been up, in more dense areas like LA, SF and San Diego(where I live) housing prices are steadily rising, almost like a mini housing bubble but I think it’s more of a correction to normalcy than a bubble.
If I were to buy a house right now, I’d probably put as small of a down payment as possible(FHA if possible) to minimize the risk of another crash. I think prices will continue going up and they will steadily slow down or there will be a sharp adjustment but I don’t think they’ll remain where they are.