On August 1, 2020, I took out a 7/1 adjustable rate mortgage (ARM) at 2.125%. I could have gotten a 30-year fixed-rate mortgage for 2.75%. However, I wanted to save 0.625% in interest.
Years later, mortgage rates have zoomed higher thanks to the pandemic, massive stimulus spending, a war in Ukraine, a war in Israel, and supply chain issues. Inflation reached a 40-year high in June 2022.
Do I regret my decision to get an adjustable-rate mortgage over a fixed-rate mortgage?
My answer is “no,” and let me tell you why.
Why I'm Fine With An ARM Despite Higher Mortgage Rates
Back in 2020, we just had our second baby and wanted a fully remodeled home to house our family. We had been living in a home that was in the middle of a long gut remodel. Given I thought the remodel would take longer than expected, I decided to pounce on a nicer home.
I fully admit I did not anticipate inflation and mortgage rates surging to the levels we saw in 2022. However, despite higher mortgage rates, I still have no regrets getting an ARM.
I know I'm in the minority and will likely get heat for my views. After all, only between 5% – 10% of mortgage borrowers get Adjustable Rate Mortgages. But hear me out. Seeing a different perspective is good when it comes to making financial decisions.
1) I'm saving money with an ARM
Instead of paying 2.75% for a 30-year fixed mortgage, I'm paying 2.125% for a 7/1 ARM. Every year that goes by, I'm saving almost $10,000 in interest expense.
Over the seven-year fixed duration, I will likely end up saving ~$65,000 in gross mortgage interest expense. Saving money feels great, not bad!
Even if I were to pay a much higher mortgage rate after my ARM expires, I have a $65,000 buffer before I start paying more due to getting an ARM. I calculate that break even period will start in the eleventh year of my ARM, even if mortgage rates stay at current elevated levels.
Please know that ARM rate adjustments have caps. The cap is usually at most a 2% increase in the first year, and 1% a year after.
2) The house has appreciated in value
Buying the house in mid-2020 turned out to be a good move. The value of the house is up between $300,000 – $500,000, even after a 5% – 10% slump since 2022.
The combination of saving money on mortgage interest expense and experiencing home price appreciation feels lucky. The home price appreciation dwarfs any amount of increased mortgage payments I will need to pay after my ARM expires.
If the house depreciated in value, then I would still feel better knowing that I'm paying a lower mortgage interest than I had to. But of course, I wouldn't feel as good.
3) ARM interest increases have limits
I want to reemphasize an ARM interest increase has a cap. All ARMs should have a limit on how much the mortgage rate can increase the first year after the fixed-rate duration is over. Subsequent years also have interest increase limits. There is also a maximum mortgage interest rate limit increase for the life of the loan.
In my case, my mortgage rate can go up a maximum of 2% in year eight, another 2% in year nine, and up to a maximum interest rate of 7.125%.
Below is an example of an ARM interest limit increase of an $850,000, 5/1 ARM at 2.375%.
As you can see from the example above, the mortgage increases can go up every year up to a limit. Therefore, you can model out potential worst-case scenarios in the future to see if you'll be able to afford your mortgage.
Thankfully, most people get raises and grow their net worths over time. As a result, they will be better able to handle higher payments in the future.
4) Mortgage principal gets paid down over time
Every month, $3,450 of my mortgage payment goes to paying down principal. Every month a little more of the payment goes toward paying down principal. In 84 months, when my 7/1 ARM expires, I will have paid off around $330,000 in principal.
If mortgage rates are higher in year eight, then I will pay a higher mortgage interest rate of up to 4.125% for one year. But I will also be paying interest on a ~20% lower mortgage balance.
As a result, my actual monthly payment will only increase by about one percent. Even if my mortgage interest rate increases by another 2% to 6.125% in year nine, my monthly mortgage payment will only increase by about nine percent.
The worst-case scenario of paying one percent to nine percent more in years eight and nine will be hardly noticeable. The average worker who receives two percent raises a year will easily be able to afford these higher payments.
5) Have the option to refinance
Nobody knows the future. However, before my ARM expires on August 1, 2027, I have the option to refinance.
It's unlikely I can refinance to a similarly low rate of 2.125%. However, there's a good chance I could refinance to another 7/1 ARM that's under 4.125%, i.e. less than my first year adjustment's maximum mortgage rate.
If I can do a no-cost refinance at a low rate, even better. Although you pay a higher mortgage rate in a no-cost refinance, if the mortgage rate is attractive, you're still winning. Further, you retain the option to refinance again without feeling bad that you paid fees for refinancing.
I believe the long-term trend for inflation and interest rates is down. We've already seen inflation peak in June 2022 and come down every month since. I'm confident that sometime between now and August 1, 2027, I'll have another window to refinance at an attractive mortgage rate.
Below is a chart that shows the historical trend of the average 30-year fixed-rate mortgage. Rates have been going down since the 1980s.
6) Fixed-rate duration of an ARM more closely matches my ownership duration
If I thought I was really buying a forever home in mid-2020, I would have been more inclined to lock in a 30-year fixed-rate mortgage and pay it down sooner. Instead, I got a 7/1 ARM partially because we will unlikely live in the house for much longer than seven years.
Based on my homeownership track record, we move every two-to-ten years given I'm an avid investor in real estate. My holding period is lower than the median homeownership tenure of roughly twelve years today.
I believe in buying a primary residence, updating it, living in it for at least two years to get the tax-free profits up to $250,000/$500,000 in profits, renting it out, and then buying another home. Over the course of a regular lifetime, a typical household could amass a four rental property portfolio by age 60 and retire comfortably off rental income.
Since 2003, I've been buying middle-class homes because that's what most households can afford. I believe this is a smart way to invest in real estate. Investing in luxury property does not give as high of a return on investment.
The Average Homeownership Tenure In America
Below is the average homeownership tenure from 2005 to 2022 according to Redfin. At about 12 years today, getting a 30-year fixed-rate mortgage is a big 18-year overshoot for the average homeowner. I've only owned my current home for three years and I'm already itching to upgrade homes. Know thyself!
Although I love our current house, I will likely be disappointed if we are still living in it seven years from now. This means we will have not relocated to Oahu. It will also mean we lived too frugally. In seven years, the house will likely decline to less than ten percent of our net worth.
As someone who has entered into his decumulation phase of life, my goal is to try and spend more money, not less. And one of the easiest ways to spend more money is to own a nicer house.
7) The worst case of paying more isn't so bad
With principal paydown and the savings I'm accumulating from having a seven-year adjustable-rate mortgage, I will have a large buffer in case mortgage rates skyrocket in year eight and beyond. But let's say mortgage rates do surge long after my savings buffer is exhausted. Not a big deal.
Chances are high that ten years after I first took out the 7/1 ARM, my net worth will be higher. That's usually what happens when you continuously save and invest.
In an high inflation, high mortgage rate environment, we also get to earn higher risk-free income through Treasury bonds, CDs, and money market funds. For example, today we can all earn over 5% risk-free in one-year Treasury bonds. We can ride the inflation wave too.
Even if your absolute mortgage amount goes up, if the mortgage payment as a percentage of your income goes down, you will feel fine. There's a reason why I encourage everyone to follow my 30/30/3 home buying rule.
8) An ARM keeps me motivated to grow more wealth by a particular time
Having an ARM motivates me to pay down debt quicker. When you have a shorter time horizon to get something done, you tend to be more focused.
If I had a 30-year fixed-rate mortgage, I wouldn't work as hard, pay as close attention to my finances, or pay down debt as intentionally. With a 5/1, 7/1, or 10/1 ARM, I treat the introductory fixed-rate period as a deadline to earn as much as possible and/or pay down as much mortgage debt as possible.
One of the key tenets of a Financial Samurai is to achieve financial independence sooner, rather than later. Taking thirty years to pay off a mortgage is not the way. An ARM motivates me to take more action to secure my financial future.
Congrats To All Who Refinanced Or Got A New Mortgage At The Bottom
Refinancing or taking on a mortgage in 2020 or 2021 is one of the all-time great financial moves. It's hard to see mortgage rates getting back to those levels again.
Whether you got a 30-year fixed-rate mortgage or an adjustable-rate mortgage, feel good knowing you got a historically low rate. The double benefit of living cheaply while experiencing property price appreciation is wonderful.
Although paying off your home might not provide joy long-term, when you finally do, you'll appreciate that you were able to borrow so cheaply.
Despite an increase in mortgage rates, my preference towards adjustable rate mortgages has not changed. Based on my 20+ years of investing in real estate, I don't want to pay more money on debt than I have to.
Finally, I'm pleased to say that I've taken advantage of the weakness in the housing market and upgraded homes in October 2023! After three years and two months living in the home I bought in mid-2020, we now have our true forever home! The next steps are to rent out our old home or sell it.
The ARM was the best type of mortgage for us because I knew my home-buying habits. Know thyself! Every person's situation is different.
Invest In Real Estate Strategically
I'm a buyer of real estate today because prices are down and competition is soft. You may not have the cash or the cash flow to buy a new physical property, but you can dollar-cost into private real estate funds and deals.
Check out the following two private real estate investing platforms:
Fundrise: A way for accredited and non-accredited investors to diversify into real estate through private real estate funds. Fundrise has been around since 2012 and now has over $3.5 billion and over 400,000 investors. Fundrise's focus is on residential real estate in the Sunbelt region where valuations are lower and yields are higher. The demographic shift toward lower-cost areas of the country is a multi-decade trend.
CrowdStreet: A way for accredited investors to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities with lower valuations and higher rental yields. Growth is likely higher as well due to strong demographic trends.
For most investors, investing in a diversified private real estate fund is the way to go. But if you want to build your own select real estate portfolio, you can now do so as well.
Shop Around For A Mortgage
If you're looking to refinance or get a better mortgage rate, shop around online at Credible. Credible has multiple lenders who will offer personalized prequalified rates and compete for your business. Also contact your existing bank to see what it has to offer. If you have good credit, you should get a lower rate than the national averages.
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Disclosure: Prequalified rates are based on the information you provide and a soft credit inquiry. Receiving prequalified rates does not guarantee that the Lender will extend you an offer of credit. You are not yet approved for a loan or a specific rate. All credit decisions, including loan approval, if any, are determined by Lenders, in their sole discretion. Rates and terms are subject to change without notice. Rates from Lenders may differ from prequalified rates due to factors which may include, but are not limited to: (i) changes in your personal credit circumstances; (ii) additional information in your hard credit pull and/or additional information you provide (or are unable to provide) to the Lender during the underwriting process; and/or (iii) changes in APRs (e.g., an increase in the rate index between the time of prequalification and the time of application or loan closing. (Or, if the loan option is a variable rate loan, then the interest rate index used to set the APR is subject to increases or decreases at any time). Lenders reserve the right to change or withdraw the prequalified rates at any time.
Hi! I love your news letters, they are so informative and entertaining. I can actually sense you truly enjoy this incredibly important work! I don’t understand RSU, how to best invest the truancy of money or how to save for the tax implication. Can you shed some light on the topic? It is not enough money to change our lives but if not saved or invested well could lead to trouble.
Thank you!
At the time we refinanced our primary in 2020, First Republic offered us a no cost Refi for a ARM at 2.6 (7/1) vs a fixed at 2.75 (30 year). JUMBO, we owed 830k on a house in so cal worth ~1.7 at the time, now worth 2.1.
Since the rates were so close, we opted for the fixed. Had there been a much larger spread, we would have opted for the 7/1. We had come off previous houses of having some great 7/1-10/1 I/O Arms- where we had ultra low payments that allowed us to expand our rental portfolio because our DTI was much lower with the smaller payment on our primary and allowed us to aggressively save cash.
From 2019-2021 we refinanced/purchased & expanded our rental portfolio to 4 SFH’s (we had 6, but flipped one and sold 1 underperforming condo) in heartland America, all long term rentals, all financed on 30 year fixed rates between 3.3%-4%. These were all purchased with 20-25% down payments. At the time we were using Movement Mortgage to finance them, as our lender could close within 10-14 days, allowing us to be extremely aggressive on the purchasing prices. Their 7/1 ARMs were often HIGHER than the fixed rates at the time, or the same.
Do we have any regrets on the fixed mortgages? Definitely not, especially on the rentals. Had we been able to secure a low 2% ARM on our primary- we would have gone that route- and we had an offer close to that, but it was with Wells Fargo, and having had several loans with them before, I had no interest in working with them again, and they also changed the amount of money they wanted us to deposit with them 3 different times to get that rate. I have no confidence in them whatsoever, or them actually closing the loan especially during Covid.
Although I’m sure things will change with First Republic now, I will say they were a pleasure to work with during their time as FRC and were a great lender/bank/partner.
We have been tempted as of late to sell some of the rentals and realize the gains, but after looking at 15-20% Capital gains + 3.8% net investment income tax + 11% state income tax, I’ve come to the conclusion that it doesn’t make sense to sell them right now. I’ll wait until we can 1031 a couple of them to a house out here in the mountains or the desert that we can use as a rental/vacation house and actually enjoy. That 70-100k in tax loss can go a long way towards the down payment when combined with the remaining equity towards a vacation home/rental out here. My wife and I are DINKS, in our latter 30’s and could use the write off’s as well during our income earning years.
I’d love to acquire another property or two prior to lending regulations change, as I’m sure it’s going to get tougher to own a personal rental portfolio as time goes on. At this point, if we could find the right property on an ARM I’d be happy to do so. Time will tell.
Yeah, I would have gotten a 30 year as well given your spread was only .15%. Every bank is different based on their loan book and what type of mortgage they want to offer to earn profits.
Refinance in 6/2021 for 7/1 arm at 2%. I have the calculations I will pay only $107,866 interest versus $137,449 over the same time at 2.75% 30 year fixed. Plus I will have paid down an extra $10k in principal. No regrets. I cap out at 7% with a much lower principal and less interest paid. So I’ll for sure come out ahead.
10 yr FRM @ 2.45%. Adding extra
Principal each month. Happy as a clam with it. Not a proponent of ARMs. My mindset doesn’t like potential uncertainty.
Best article yet. Fantastic analysis. IMO IOs were viable in an era of declining rates, but now that we’re going to be in a prolonged era of higher rates and likely hard asset deflation that product is no longer viable. I was offered a no cost 1.99% / 15 Y FRM refi early in the pandemic and I took the plunge. I’ve always been averse to excessive leverage and there is an element of diversification via the accelerated principal paydown.
You mentioned – “I believe in buying a primary residence, updating it, living in it for at least two years to get the tax-free profits up to $250,000/$500,000 in profits, renting it out, and then buying another home.”
My question is – How do you get 121 exclusion (500k cap gains) unless you sell your primary residence within 3 years? In your scenario, don’t you have to sell within 3 years?
I don’t. It’s just a goal. My goal is to hold onto my properties for as long as possible.
Alas, I failed at one property in 2017 b/c I wanted to simplify life and focus on raising my son.
See: Clarifying The $250,000 / $500,000 Tax-Free Profit Rule, if you want to rent out the place, and move back in to try and save on taxes if you then want to sell.
I knew you had a winning mortgage when you first got it in 2021 particularly since it was a 7 year. I think it were a 3 or 5 year, that would have been regrettable. Personally I got a 2.375% rate for 30 years but I/O for the first 10 years.
Before that for two decades I normally got a regular 30 year fixed mostly out of ignorance and risk aversion. You definitely “won” with the ARM strategy. However I always have been in strong opposition of your pay of your mortgage strategy because it “feels good”. Now that interest rates have gone up you agree it makes no sense to pay off your mortgage but it’s too late for those people that already paid it off.
I’m a big fan of a fixed 30 year mortgage for peace of mind. No surprises and you know what you’ll pay for the next 30 years…
It’s hard to predict the future and whether you’ll truly move in 7 years. Where will housing prices be? I don’t think we’re going to see sub 3% mortgage interest rates for a while.
But understand your points. My first house was bought with a 5/1 ARM for the lower interest rate. At this point in my life, the additional amount on a 30 year mortgage compared to a 5/1 or 7/1 while substantial, wasn’t enough to motivate me to deal with the unknown after the fixed rate expires on an adjustable.
When you’re retired, you want to deal with as much constants as possible. If you can control your Fixed Income and your Costs, there’s a lot more comfort in retirement.
You’ve got to do what’s best for yourself. If a 30-year helps you psychological, then that’s most important.
For me, I don’t plan to have a mortgage after 60 and I don’t want to pay more for interest than I have to.
You convinced me. We always got fixed-rate mortgages, but ARM looks like a better choice now. We don’t stay in one home that long. Well, it seems we move every 10 years or so. ARM would work better in this case. I don’t think we’ll find a forever home. Gotta keep moving like a shark. haha.
To those on a mission to pay off their mortgage in today’s economic climate…Currently, the risk free rate of return of a T-bill or CD is > 5%. Making extra payments on a mortgage with an interest rate less than 5% is equivalent to throwing away free money. Would you ever say “no” to accepting a company match on a 401k? Never. So why throw away free money from a T-bill or CD? I am genuinely curious to understand the train of thought.
Don’t think most people are paying down extra when their mortgage has a negative interest rate.
But I also think most people never regret paying off debt.
Cash flow. If I can pay off my mortgage a year early, that’s one year sooner that I don’t have to make that payment and possibly retire or semi-retire.
However if the after-tax advantage between the mortgage interest and T-bill yield was there, I would probably contribute into T-bills until that balance was enough to pay off the mortgage, and then pay it off.
Interesting. I wonder if I am making the miscalculation (from a financial perspective, not a psychological perspective) ? I have a 30 year fixed mortgage at 2.75% with a balance of 475k. I now have an equal amount of cash in short term T bills and CDs at over 5%. Would I be better off just paying off the mortgage now? I was thinking it best just take that risk free spread between the two rates and live “for free” as the interest gained in the T-bills and CDs covers the cost of living in the house. What would the FS community do in that situation? Thanks!
I’d just keep earning 5%+ until you can only earn around 3%. At that level, you can start paying down your mortgage more if you want. I’d rather have less debt.
Your current situation is netting you $890/mo. before tax implications. Would you rather have that or no mortgage payment?
10/1 I/O 3% expires in 2030 not worried in the slightest. Motivates me to grow my wealth and try & pay it off. People hate interest only loans but every time I make a principal payment my mortgage payment drops the next month. Love the flexibility of extra cash flow as I run my personal finances like a business
Same here. And it feels good to have an accelerated challenge.
I have the same structure. 10/1 IO 2.375 expiring in 2031. Impossible to forecast that far into the future, but there’s a medium to high probability that I’ll have a chance to refinance at an attractive rate if I’m patient. I also closely run my personal finances like a business and am very diversified.
If the average home ownership tenure is now about 12 years, wouldn’t a 15 year fixed mortgage be acceptable?
Or do you think people don’t qualify for a 15 year fixed due to the higher monthly payment vs a 30 year fixed?
When we purchased our current “forever home” back in 1987, interest rates were very high and going higher. We didn’t qualify for the higher payment of the 15 year fixed at the time of purchase (so ended up with a 30 year fixed), but we were able to refinance into a 15 year loan 3 years later when interest rates went down a bit. We eventually paid off our house in 2005 after 18 years of mortgage payments.
I suppose we were too young, stupid, and fearful (?) to even consider an ARM at the time of purchase and refinancing. Neither one of us understood ARMs – and didn’t have the bandwidth at the time to learn about them – so we avoided them like the plague!
Yes, 15-year FRM are great if one can afford the higher payment. I’m a fan!
10/1 ARMs too. Good to match duration of ownership.
Looks like the lowest APR ARM is currently 50bps higher than the highest 30yr fixed right now. I’m guessing they think rates are going to be much lower 3-5 years from now.
Would it be better to bet on the ARM now or pay the cost to refinance later?
You are making several great arguments there, many of which I had not considered when choosing from loan options. Reflexively I always went 30-year fixed. But your reasons are very solid and may make me reconsider next time!
I had a long thought process before I got my mortgage on which way to go. My banker was trying to push me to take a 30-year fixed, but I felt hesitant on the terms and slept on it for a bit. I ended up getting a 5/1 ARM and am at peace with it. I am motivated to pay my mortgage off asap and have been paying down extra principal for the last several years.