An adjustable rate mortgage (ARM) is the best type of mortgage rate to get. If you are considering between a 30-year fixed rate mortgage, a 15-year fixed rate mortgage, or an adjustable rate mortgage, you will likely save the most money with a 5/1 ARM, 7/1 ARM, or a 10/1 ARM.
Adjustable rate mortgages are not as popular as 30-year fixed-rate mortgage. By promoting peace of mind, especially to first-time homebuyers, lenders try and push 30-year fixed rate mortgages to earn more money. Their profit incentives are strong. Larger loans with longer durations that charge higher mortgage interest rates are more profitable.
Thankfully, you have the ability and willingness to learn about other options. Here are three main reasons why I think an adjustable-rate mortgage is better than a 30-year fixed-rate mortgage to save you money.
Three Main Reasons Why An Adjustable Rate Mortgage Is Best
1) The long-term interest rate trend is down.
Mortgage rates are highly correlated to the 10-year Treasury bond yield. And the 10-year Treasury bond yield has been coming down since the 1980s as the Federal Reserve has become more efficient in managing economic cycles. It is unlikely this downward trend will change any time soon thanks to technology, swifter economic policy, and coordinated central bank efforts.
Of course, there is no guarantee that interest rates will stay down forever. But in order for mortgage rates to go up, the U.S. would have to completely lose its superpower status, causing foreigners to dump Treasuries in lieu of another international safe haven. The Fed Governors would also have to become inept at their jobs. Further, the internet would have to disappear.
Taking out a 30-year fixed-rate mortgage means you are betting against a ~40-year trend of declining rates and rising economic and intellectual progress. Instead, take out an adjustable rate mortgage that makes a bet that interest rates will stay lower for longer.
2) A better match to the average length of homeownership
The average homeownership duration is about eight years in 2020. This is a big increase from just four years between 2000 – 2009. Therefore, taking out a 30-year fixed rate mortgage makes little sense. You will be paying a higher interest rate for the duration of your homeownership than necessary.
Instead, it is much more efficient to take out an adjustable rate mortgage that more closely matches your estimated homeownership period.
For example, if you plan to live in your house for 8-10 years, taking out a 10/1 ARM is the most ideal loan duration to save money. A 10/1 ARM is usually between 0.25% – 0.5% cheaper than a 30-year fixed-rate mortgage.
3) ARMs have an interest rate cap
One of the biggest fears perpetuated by proponents of the 30-year fixed-rate mortgage is that once the ARM's fixed-rate period is over, the interest rate will shoot higher and make monthly payments unaffordable. This simply isn't true due to mortgage interest rate caps.
There is a cap on the annual interest rate increase for the first year. There is another cap usually for the second year. And then there is a lifetime interest rate cap. Unless your lender is trying to swindle you, there is no endless increase in interest rate increases. Of course, please double check with your lender by asking what the interest rate cap is.
For example, I got a 5/1 ARM in 2014 for 2.5%. In 2019, the most it could reset to was 4.5% for one year. The ARM could reset by another 2% in the second year all the way up to a maximum of 7.5%. But of course, instead of allowing the ARM to reset, I refinanced my mortgage for no fees to a 7/1 ARM for 2.625%.
More Reasons Why An ARM Is Preferred
If you are still unconvinced that an adjustable rate mortgage will likely save you more money over a 30-year fixed-rate mortgage, here are more reasons to consider. At the very least, these reasons should make you less afraid of taking out an ARM.
1) Principal still gets paid down
Unlike a negative amortizing loan or interest-only loan, an ARM pays down principal with each payment. Therefore, when it comes time to refinance your ARM to another ARM, there will be less principal to refinance. If the mortgage rate stays the same, then the monthly mortgage payment will go down
If you let the ARM float, then the interest will be applied to a lower principal amount. Finally, if the absolute mortgage payment stays the same, the percentage of the payment that goes to principal will go up.
Even if you pay no extra principal during a five year period, your principal balance will decline by 10% – 11% due to normal monthly mortgage payments.
2) An ARM makes you more disciplined
Think of an adjustable rate mortgage like a personal finance trainer. The trainer motivates you to stay on top of your finances and pay extra principal every month. Think of a 30-year fixed mortgage as your neighborhood gym. You hardly ever go, even though you know you should.
An ARM gives you a shorter timeline target to reduct debt and build wealth. When you have 30 years to pay off debt, the tendency is to take your time.
3) Higher rates may be a good thing
Things don't happen in a vacuum. The 10-year Treasury yield is a reflection of inflation and economic growth expectations. If the 10-year yield and mortgage rates are higher, this probably means inflation is elevated or expectations for inflation are also rising because demand is rising.
Even though you might have to pay a higher mortgage rate, the value of your real estate will likely also be higher due to stronger demand.
Given the cost of ownership is largely fixed, real estate is not only an inflation hedge, but it is also an inflation play. In an extreme circumstance where there is hyperinflation, you need to own real assets such as real estate, not cash which is rapidly losing its purchasing power.
4) You are adaptable
You are not a zombie. Let's say you get lucky and rates aggressively rise during your fixed-rate period. Before your adjustable-rate mortgage floats, you can do a number of things:
- Pay down more principal to lower your future mortgage payments
- Refinance your mortgage before the rate floats
- Sell your property
- Generate income from the property by renting out a room, a floor, or the entire property
You have plenty of time and plenty of options to make a positive financial move before your ARM resets to a higher rate. When there is a mortgage market anomaly, sometimes the 15-year fixed rate is lower than a 5/1 ARM. In such a situation, it's worth taking advantage.
5) An ARM may provide more peace of mind
The more uncertainty and fear there is in the economy, the lower mortgage interest rates tend to go as investors seek the safety of US Treasury bonds. Therefore, the lower interest rates go, the less peace of mind you may have with a 30-year fixed mortgage because you're stuck paying a higher mortgage rate than necessary.
Think about how annoyed you felt after you bought something and the store cut prices after your return policy was over. Overpaying is a terrible feeling.
Quantify Your Peace Of Mind
If you value peace of mind with a 30-year fixed rate mortgage, quantify it.
Let's say you can get a 30-year fixed loan for 3.25% vs. 2.125% for a 7/1 ARM with no fees. Let's say you borrow $1 million. $1 million X 1.125% (difference in the rate) = $11,250 more in interest expense you will have to pay every year for the length of ownership.
If you own the home for seven years and then sell it or pay off the mortgage, that's $78,750 more in extra interest expense you would have paid for the comfort of having a 30-year fixed rate mortgage.
Even if you planned to spend 30 years paying down your mortgage, if interest rates stay the same or go down, you would be better off taking out an ARM and refinancing after every adjustment or letting the rate float.
The only way the 30-year fixed-rate mortgage holder comes out ahead is if interest rates surge higher after the fixed rate period of an ARM is over, no extra principal is paid down, and the homeowner plans to take a long time to pay off the mortgage.
In the above example, the 7/1 ARM holder at 2.125% would have to pay roughly a 4.375% interest rate for seven years after the ARM floats for the ARM holder to regret not taking out a 30-year fixed mortgage. Before the 14 years is up, the homeowner will have likely paid down a lot of principal, sold the property, or refinanced.
Please Buy Responsibly
If you do decide to buy a home with an adjustable rate mortgage, please follow my 30/30/3 home buying rule and buy responsibly. Some people get in trouble by buying too much house because their ARM interest rate is much lower.
Eventually, you may want to build a rental property portfolio. Buying more than your primary residnce is really the only way you're long property. Only owning your primary residence means you are neutral real estate since you have to live somewhere.
The easiest way to build a rental property portfolio is to buy a primary residence, rent it out after several years, and buy another primary residence. After repeating this process for 20+-years, you'll likely have a nice stream of passive retirement income.
Real Estate Investing Suggestions
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