Given inflation and mortgage rates have gone up aggressively since August 2020, was getting an ARM back then a bad move? Maybe. But I'll argue probably not. Let me reason why.
One of the best things about running Financial Samurai is having readers criticize my financial beliefs and actions. So long as the criticism is respectful, I find the criticism to be one of the best ways to learn. After all, if we're stuck in an echo chamber, it's hard to outperform.
Now that we've seen big rises in inflation and mortgage rates, I've received a couple of comments saying that I was wrong for sticking with my ARM recommendation call. It's always easier to point out mistakes after the fact.
For reference, I've been writing about how an adjustable rate mortgage is preferable to a 30-year fixed rate mortgage since 2009, when the 10-year bond yield was at ~4%. I've actually held this belief since 2004, five years before I started Financial Samurai. Today, the 10-year bond yield is at ~3.4% after rebounding from a 0.52% low in 2020 and reaching a high of about 4.2% in mid-2022.
In other words, my public call to get an ARM and save on mortgage interest expense has been correct for at least 13 years. I was finally wrong in 2022 when mortgage rates shot higher due to higher inflation. But mortgage rates have since fallen once more.
In the world of “what have you done for me lately,” let's do some analysis!
Argument For Why Taking Out An ARM Is Bad Advice
First, let me share the latest criticism that motivated me to write this post. Deon writes,
“I have been a long-term subscriber and like most of your comments. I even invested in Farmland through your site. What boggles my mind as a 30+ real estate investor is HOW on earth were you advising folks to refinance into 5-7 year adjustable rate mortgages when rates for a 30-year FIXED were at in the mid 2.5% again FIXED.
That is simply insane advice. It was FREE money for 30 years. There is no other way around that fact EVEN if would you were to sell in 3-5 year timeframe to avoid or reduce capital gains. These were ridiculously LOW rates to give people option to NOT sell. Really BAD advice and sorry have to call you out that one.”
I've always thought I was in the business of writing, where I share my thoughts freely (bad business!). But if I'm in the advice-giving business, I should consider charging. But it's always easier to offer refunds when everything is free.
Mortgages By Interest Rate
If Deon was able to get a 30-year fixed-rate mortgage at 2.5% that is a fantastic rate. Back in 2020, the lowest quotes I could get for a jumbo 30-year fixed was around 2.75%.
Roughly 8.8% of mortgage holders have a mortgage interest rate at 2.5% or less. So if you got a 30-year fixed-rate at 2.5% or less, consider yourself special and lucky.
Here is a break down of mortgages by interest rate.
If I was able to get a 30-year fixed-rate mortgage rate at 2.5%, I'd be very tempted to lock one in as well. It's a phenomenal rate for 30 years of peace of mind.
However, if I could get a 2.5% quote for a 30-year, I could also probably get a 1.75% quote for a 7/1 ARM. If so and if I went with the ARM, I would still be saving 0.75% in interest expense a year for seven years over a 30-year fixed mortgage.
An Adjustable Rate Mortgage Has An Interest Rate Cap
Once the introductory fixed-rate term expires, an ARM has an interest rate cap, usually no more than 2% the first year (from 1.75% to 3.75% in this example) and 1% every following year (from 3.75% to 4.75%, etc). An ARM also has a lifetime interest rate cap, usually no more than quadruple the rate. In this case, the maximum interest rate would by 7%.
If you do the math, the 30-year fixed rate mortgage would start becoming a better deal at about year 10, or three years after the fixed-rate period is over. But this is only if mortgage rates rise by over 2% in year eight and stay higher by 3% in year nine and later.
At the moment, two years after Deon said he could have gotten 2.5% on a 30-year fixed, we have experienced a ~2%+ increase in mortgage rates. But will inflation stay at 40-year highs for another six years? I don't think so.
A person who took out a 7/1 ARM in 2020 that expires in 2027 doesn't really care if interest rates rise by 10% today. Even in year eight, if mortgage rates are still 10% higher, the most the 1.75% ARM can go up is to 3.75% and by 1% every year until the cap is reached at 7%.
I'm not sure if Deon or most people know this because most people don't take out ARMs. Only about 10% of total mortgage holders have ARMs. The percentage was only about 5% before 2021.
Historical Mortgage Rates
Below are the average mortgage rates for a 30Y FRM, 15Y FRM, and 5/1 ARM from Freddie Mac.
Deon, the commenter, uses the all-time low as an example and then quotes 2.5% for a 30Y FRM, 0.27% below the all-time low average. Cherry-picking data to make your argument is a good strategy.
It is also a good test for the counterargument, which I'm providing.
Average Homeownership Duration
Let's continue to assume the worst-case scenario for the ARM holder, that interest rates surge higher soon after taking out an ARM and stays higher for years.
In 2023, the average U.S. homeownership tenure is about 11 years. To favor the 30-year fixed-rate mortgage argument, let's now assume the average homeownership tenure is closer to nine years in 2022.
If you are the average U.S. homeowner, you would sell your property after nine years. Therefore, the average U.S. homeowner who takes out an adjustable rate mortgage would still benefit from taking out a 7/1 or 10/1 ARM in a realistic worst-case scenario. Again, the break even point where a 30-year fixed-rate mortgage makes sense in a worst-case scenario starts at about year 10.
An 8-to-10-year average holding period for a home sounds reasonable. Most of us are getting wealthier each year and have desires to upgrade after 10 years. For folks like me, who suffer from real estate FOMO, 8-to-10 years might feel a little long.
For example, I just bought my “forever home” in June 2020 and I'm already itching to buy a nicer home with a great floor plan. By 2027, when my 7/1 ARM resets, the loan balance will likely be at least 20% lower, providing an extra cushion in case rates are higher. But the long-term trends for interest rates are mortgage rates is down. So I’m not worried.
What Happens To Home And Rent Prices In A High Inflationary Environment?
The Fed hikes the Fed Funds rate in an attempt to curb inflation. High inflation is usually due to a strong labor market and a strong economy. What happens to property prices and rents in a strong economy? They usually go up. Inflation acts as a tailwind for property prices, while property prices are a component of inflation.
What people who criticize ARMs may be missing is how secondary the debate between getting an ARM or a 30-year fixed-rate mortgage is. The comparative gains in real estate values in a high inflation environment far outweighs the savings one could get from either type of mortgage.
The Rise In Property Values Dominates The Debate
For example, let's say you purchased a $1 million property in May 2020, the bottom of the most recent real estate market cycle. March 2020 is when lockdowns began and public open houses stopped. May is around when sellers panicked the most.
If you bought a $1 million property in May 2020, by May 2022, your property was worth between 20% – 50% more, depending on where it is in the country. In other words, you're up about $200,000 – $500,000 in two years.
Let's say you got a $800,000, 7/1 ARM at 1.75% versus a 30-year fixed at 2.5%. Your annual gross interest savings because you took out an ARM is $6,000. Over two years, your annual gross interest savings is $12,000. Congrats for taking out an ARM in a rising-interest rate environment!
But $12,000 in gross mortgage interest savings accounts for only 2.4% to 6% of the $200,000 – $500,000 you're up on your property. And after saving $42,000 in gross mortgage interest for seven years taking out a 7/1 ARM, are you really that worried if your ARM resets from 1.75% to 3.75%? Of course not. Your job income or rental income is likely much higher by then as well.
It’s easier to generate passive income in a high interest rate environment. Too bad high interest rates won’t last forever as inflation returns to its long-term downward trend.
Inflation Will Boost The Value Of Your Property
If inflation is still rocking at 40-year highs 10 years after you took out a 7/1 ARM, your property's value has likely gone up another 50% – 120%. That's another $600,000 – $1,440,000 in real estate equity gains!
So you're now paying a 5.75% mortgage rate in year 10 compared to only 1.75% from years 1-7. Your payment went up from $2,858 to to $4,669.
Paying an extra $1,811 a month sounds like a lot. But is it really if your property is up $800,000+ since 2020 and you saved $42,000 in gross mortgage interest expense for the first seven years you had your 7/1 ARM? Not really.
Thanks to inflation, your $4,669 monthly mortgage payment in year 10 won't feel as bad as it sounds today. It will actually probably feel closer to the $2,858 mortgage payment you are paying today after adjusting for inflation.
Inflation is one of the main reasons why I like to invest in physical real estate and real estate online like with Fundrise. As investors, we want to ride the inflation wave to greater wealth, not get pummeled by it. I plan to invest in real estate, especially in the Sunbelt, for decades to come.
The ARM May Have Made Homeowners More Money
Here is another consideration. Since taking out an ARM enables a buyer to more easily afford a home, an ARM could have made the difference in buying or not buying. Or an ARM could have enabled a buyer to buy a more expensive home than they would have with a 30-year fixed-rate mortgage.
So long as a buyer doesn't pay more than 5X their household income for the price of their home, they are relatively safe in their home purchase.
Let's see who wins in a housing bull market.
In a bull market, a person who bought a home with an ARM vs. a person who didn't buy a home because they couldn't afford to buy with a 30-year fixed-rate mortgage? The ARM holder.
In a bull market, a person who bought a home with an ARM vs. a person who bought a 10% cheaper home with a 30-year fixed-rate mortgage? The ARM holder.
Of course, the homebuyer with a 30-year fixed-rate mortgage since 2020 has also made a healthy return on their investment. They are just paying a higher mortgage interest expense. But again, a higher mortgage doesn't really matter given the real estate returns since then.
Whether you borrow at 2.5% for a 30-year fixed or at 1.75% for a 7/1 ARM, you're still borrowing “free money,” as Deon comments. The reason is because inflation at 8.5% is much higher than both those rates. The 7/1 ARM rate is just “more free” than the 30-year fixed rate as both are negative real interest rate mortgages.
Spending 30 Years To Pay Off Your Mortgage
If you want to spend 30 years paying off your mortgage, then getting a 30-year fixed-rate mortgage becomes more attractive. In this case, the peace of mind you are buying with a 30-year is more valuable.
Let's say you have no ability to make extra income to pay down your mortgage quicker. You also don't have any energy or ability to refinance your mortgage. Finally, you also believe we are in a permanently-high inflation and interest rate environment.
When you look at the below chart, you don't believe in the 40-year downward trend in inflation since the 1980s. Instead, you believe inflation will go back to the 1980s level and stay elevated for at least a decade. The red line will keep on going up like a rocket ship!
If this is the case, getting a 30-year fixed-rate mortgage was and is appropriate. Don't let me or anybody else tell you otherwise!
Happily Holding My ARM
Personally, I'm glad to have taken out a 7/1 ARM in 2020 for 2.125% with all the fees baked in. I firmly believe inflation and interest rates will resume their downward trend well before my introductory rate period expires in June 2027.
But in the 20% chance scenario I'm wrong, I'll have several years after the introductory rate period is over before I start losing. But I don't plan to lose. I plan to rationally pay down more mortgage debt if interest rates are higher. Or, I plan to refinance my mortgage to another ARM if interest rates dip again. I might even sell my home before 2030 and buy a nicer one.
As an ARM holder, I'm not afraid because above-trend interest rates and mortgages rates rarely last longer than three years. After three years, inflation and interest rates begin to fade once more. There’s another buying opportunity in 2023 as mortgage rates decline.
The irony is, as a real estate investor, you want inflation to stay elevated. Not in the 8%+ range, but more in the 4% – 5% range. This way, mortgage rates will come down, demand for real estate will go up, and rents will continue to rise. You want to own and keep renting out your property in a high inflation environment.
I know I'm part of the 5% minority of ARM holders. For this reason, I'm viewed as an anomaly. I might also be viewed as stupid or taking excessive risks by those who've never taken out an ARM. It's understandable to dislike what we don't know.
But since taking out my first ARM in 2004 and refinancing multiple times as rates have come down, I've had a good 18-year run. I've saved more than $350,000 in mortgage interest since 2004. If I start to lose beginning in 2027, then so be it. But for now, I've got another five years of mortgage interest savings to go.
Make Your Own Mortgage Decision And Be Satisfied
You don't have to follow my lead as our financial situations are different. Just make sure you run the mortgage numbers under various scenarios.
I just want to save and make the most money possible. And to me, matching your mortgage's fixed-rate duration to the length of time you plan to own your home makes the most sense.
Based on my history, I have yet to let a mortgage last beyond 15 years. I've either paid off the mortgage, refinanced it, or sold the property. Hence, taking out a 7/1 or 10/1 ARM makes the most sense to me.
If you want to shop around for a lower mortgage rate, check online here. You'll get multiple free, real quotes to choose from so you can save money. The more lenders you can get to compete for your business, the better.
Invest In Real Estate More Strategically
Real estate is my favorite way to achieving financial freedom because it is a tangible asset that is less volatile, provides utility, and generates income. Stocks are fine, but stock yields are low and stocks are much more volatile.
Take a look at my favorite real estate investing platforms, Fundrise. It is free to sign up and explore. Fundrise focuses on single-family and multi-family rental properties in the Sunbelt, where valuations are cheaper and rent growth is stronger.
Fundrise is a great way diversify into real estate through private eFunds. Fundrise has been around since 2012 and has consistently generated steady returns, no matter what the stock market is doing. The real estate platform has over 300,000 investors and manages over $3 billion.
I've personally invested $810,000 in real estate crowdfunding across 18 projects to take advantage of lower valuations in the heartland of America. My real estate investments account for roughly 50% of my current passive income of ~$300,000.
Readers, why do you think the majority of people still are against ARMs? Do you think there's a correlation between financial knowledge and one's views against ARMs? Please share what type of mortgage you got and why. Were you able to get a 30-year fixed-rate mortgage at 2.5%?
To go deeper into building greater wealth, pick up a hardcopy of my new Wall Street Journal bestselling book, Buy This, Not That: How To Spend Your Way To Wealth And Freedom. If you enjoyed this debate about whether to take out a 30-year fixed or an ARM, you will love the book as I tackle some of life's biggest dilemmas.
Join 60,000+ others and sign up for my free weekly newsletter. Everything I write is based off firsthand experience and my knowledge as a finance veteran since 1999. Because money is too important to be left up to pontification.
Amazing site and post Sam. I have been reading for years, first post though.
I bought in Oct 21. $4M loan. The loan officer was pushing me to a 10/6. On the day we locked I asked her what the 30 fixed was and it was only a quarter point higher. So I was looking at a 10/6 at 2.125 or a 30 fixed at 2.375. The 7/1 wasn’t better due to the size of the loan. The way I looked at it the quarter point spread wasn’t worth the risk. I probably could have rolled the dice, but I don’t see us moving from our current property for over a decade due to timing of kids schools so locking a 30 year fixed at 2.375 was our choice and I don’t regret it for a minute. FYI I satisfied your other home buying criteria. :)
Cool. Only 0.25% higher is a historically low spread for a 30-year over a 10/6.
I hope you enjoy your mansion!
Not sure if this is within this article’s scope, but I’d be interested in reading potential interest rate hedging strategies.
Some that come to mind would be perhaps investing the difference in the monthly payment of a 30yfixed vs ARM into Ibonds – if rates stay elevated you’ll be getting a higher payment in the Ibonds that you can potentially use to offset an increase in monthly mortgage payments.
Or perhaps shorting the 30year treasuries (Easiest being ticker $TLT probably) – logic being if rates rise the ETF will fall in value.
Just some concepts – I’m not really sophisticated enough to breakdown the numbers into something actionable, but I’d be interested to hear any thoughts!
Thanks
Hello, great website here and right now you are felling pretty rich just by the fact that you have free money for 30 years. Heck you could get a T bond that almost pays your mortgage. This really drives my point of the almost free money for 30 year on a fixed rate and good for you. Don’t look back…. Wow no worries about the refi mill to keep it going. One and done.
BTW if rates for some odd reason do sub 4 it will be a refi and real estate craze bubble mania…. It will be the final goodbye to low rates for a generation.
Deon
I will say in the size of the mortgage makes a bit of difference. I recently took out a 30 year fixed for less than a $500,000 mortgage. When I was looking at rates, the spread between a fixed and a variably was less than a $100/month difference. If the difference was larger like the numbers you used, I might have gone for the variable rate.
A contributing psychological factor is the fact that my W2 income will decrease 60% in 3 years when I retire from my Federal Government Job. While I will easily keep my spending at the same level based on investments I’ve made + tax savings having a fixed rate helps me sleep better at night.
Yes, you are absolutely right! Thanks for sharing.
Researchers found the main reason why people with much higher than average mortgage interest rates didn’t bother refinancing is because their mortgage balances were so low, the cost and time to refinance them were not worth it. Makes sense!
This qn is not specific to ARM vs Fixed. Can you publish an article on how one can go about upgrading from an existing primary home with mortgage to a new one, assuming one doesn’t have income / assets to qualify for two mortgages, Should we sell first and rent and then buy, this seems risky. Will lenders allow us to qualify for a second mortgage and buy first , assuming we can afford to pay two mortgages for a few months ? I also see some startups providing some form of gap financing . I am in SF Bay area, so we are talking about multi million property prices.
This qn is not specific to ARM vs Fixed. Can you publish an article on how one can go about upgrading from an existing primary home with mortgage to a new one, assuming one doesn’t have income / assets to qualify for two mortgages, Should we sell first and rent and then buy, this seems risky. Will lenders allow us to qualify for a second mortgage and buy first , assuming we can afford to pay two mortgages for a few months ? I also see some startups providing some form of gap financing . I am in SF Bay area, so we are talking about multi million property prices.
Hi Sam
Great article. One thing to keep in mind is that for the last 40 years interest rates have been downward trend. If you would’ve taken out a seven year arm in 1970, looking at the charts the 30 year fixed may have been the better play. You are making an assumption that inflation will be resolved and contained quickly…time will tell. But I think it will be around much longer you think
Inflation won’t be resolved quickly. But I do believe inflation will normalize in three years since inflation started going up aggressively. As a result, if it takes three years for the 7/1 ARM holder to start losing after their fixed rate period is over, then even the unluckiest ARM holder who didn’t refinance in 2020 or by mid-2021, and had his rate reset in 4Q2021 will likely be fine.
Rates started ramping in 4Q2021, but I have little doubt rates and inflation won’t revert back to trend by 4Q2024. And time will tell!
I will make you another bet that inflation will be above 3.5 % at the end of 2025!
If you do 6.5%, or 2% lower than the latest July 2022 CPI print, you’re on! Anything can happen from now until then.
Come on … do you always have to the best of it..? You must be a very low stakes gambler? Your bets are always very much too your advantage. You think I am always going to give you the best of it?
I am ready to bet 20 k on a fair bet…
We can give it all to charity. We can hold all the $$ in an escrow account..
Are you ready to make a real bet
Man up
JJ
Chill out Jim, you can make any bet you want on interest rate in the open market. In general the market does not agree with you. But I’d be happy with return of inflation.
Telling someone to man up when you don’t get the bet you want is pretty weak sauce. As far as I know, it’s a free market and a transaction can only occur when two sides agree. It sounds like you are currently on the losing side of a bet or something, and just want to gain an advantage to win.
Hey Sam, so I actually got the 2.5% 30 year fixed no points you mentioned in your example, back in Jan. 2021. At the time I asked about an ARM since you had recommended it. The mortgage companies offering this lowest rate I mentioned above mentioned they weren’t offering the ARM at the time, stating something along the lines of it would be around the same rate, so there is no point in offering it. Just stating here what I was told. Some companies were offering it and it was very close to 2.5%, so I went for the peace and mind in the 30 year fixed.
Good stuff. Yes, many anomalies over the past two years. So if you couldn’t get a lower rate with an ARM, then a 2.5% 30-year fixed is an excellent choice. Congrats!
My thing against ARMs is primarily based on predictability. The more random elements I can remove from my planning, especially my long term planning, the more likely I am to achieve my aims.
True. There’s an extra price people are willing to pay for peace of mind, and bankers know this, hence the stronger push toward more profitable 30-year fixed loans.
But I’m sure if more people spend time understanding interest rates and the terms of an ARM, more would take out ARMs. It’s natural to fear or not choose what we do not understand.
Very good points, one other thing to consider, qualification for other loans.
My wife and I are DINKS, living in So Cal. We refi’d our primary to a 30 year fixed Jumbo, at 2.75 in late 2020. At that point we were at about a 50% LTV, now realistically a 35% LTV. Our banks ARM option was slightly better but we opted for the fixed.
At that time we had (3) investment properties in heartland America, and have ended up picking 3 more up since.
One thing I have noticed working with various lenders, is from a qualification standpoint, it makes it easier to qualify for other rentals and shorter escrows with a fixed on your primary. We only have our primary mortgage and 1 car payment as debt, besides the rental properties. No student loans, no credit card debt, etc.
In past instances when we had ARMS, lenders would hit us for “worst case situation” many times. Some of our rentals we had owned for less than 2 years, so they wouldn’t take rental income off them to offset.
In short- all of our rentals have been purchased with 25% down, 14 day closes, and are all on fixed rates between 2.99%-4.125% at this point (we have 6).
Would we have been able to get the loans with our primary home on an ARM? Most likely, we definitely would have qualified income wise.
Would we have been able to get the loans done in 14 days, closed within 14 days having a ARM on the primary? Doubtful. Underwriting definitely slows down and looks at every page of your ARM paperwork.
We were able to close fast and write aggressive offers because our situation was simple and clean. In the past when we had the arm and there we’re more qualification and calculations involved, the same lender couldn’t close in less than 28 days. At 28 days, there is a high probability we wouldn’t have gotten all the properties, due to so many aggressive cash offers.
Could we save money with an arm? Sure. Each property is up a lot more than 40k since we have purchased them. I’ll take the slightly larger write off, pay a little extra per year on the fixed, to be able to aggressively purchase investment properties on 14 day escrows.
Just food for thought. Not saying the ARM is wrong, but in certain situations, there can be advantages to a fixed other than peace of mind.
Sounds good to me. Thanks for sharing.
I never consider the speed of closing between the two mortgages because I always got preapproved. Once one is preapproved, it’s kind of like hang all cash for a property and you can close within 14 to 21 days usually. But of course, a reservation is different.
My mom was doing a refi last year and I tried to convince her to do an ARM. Its a small loan balance and can be paid off easily. However, she was still against it after I ran the numbers for her. She wanted the “security” and peace of mind from the fixed rate.
For myself, I am trying to refi one of my properties right now from a high 30 year fixed 6.15% rate to an ARM or even a fixed rate mortgage in the 4.x% range.
You should definitely be able to save 1% to 2% off of your existing mortgage. Good luck!
As a Canadian, most of this doesn’t apply. I’ll just sit back and smile at my 10 year 1.54% fixed and count myself extremely lucky at the timing.
Just piping up to say thank you for your work. I’ve always loved this site.
Taking an ARM has clearly worked out well for a long time in the 40-year declining rate environment. Great run. Currently, I agree that taking an ARM is better given the near term and guaranteed benefits vs. a 30-yr fixed. That said, I think you and other posters are downplaying the fact that you have a relatively extraordinary amount of available capital to “bail yourselves out” at or shortly after the reset period should circumstances turn against you.
I think you have been doing it brilliantly focusing on ARMs and you are clearly on top. That said, the average borrower who is dependent on the paycheck to make the mortgage payment should be weary and recognize the benefit of the unique value that the 30-yr fixed rate prepayable mortgage offers (unique to this country). Not saying it is the best housing finance policy but for most borrowers likely the best. For wealthy borrowers, I agree with you about ARMs even in the current environment and recent past.
Great post as always, really enjoy your personal reflection of these decisions that many of us face!
Agree – think you need to consider total assets owned without leverage, income, and the amount you plan to borrow for a non-income producing residence. Then think about the stability of your income, ease of replacing it, and the effect that would have on your mental health (some people are more resilient and/or do not have dependents)
You might be right! Although, the person with tighter cash flow would enjoy the benefit of a lower mortgage payment with an ARM, and save the difference. But as we all know, it’s harder to be disciplined with our finances than what we say or think.
No brainer for me here — August ’21 I picked a 2.375% 10yr ARM over a 2.875% 30yr fixed on a 1mm mortgage in ATX. So that comes to 5k / yr savings on interest for 10 years and could create a future value of ~75k if the 5k / yr is invested into 7.5% stock market. It’s almost like the stocks are free!!! Now, I will admit this is highly specific to my situation, but damn it feels good.
Just starting yr 2 of my 5yr ARM refinance @ 1.625%. I did basically the same analysis recently, and agree with your analysis. One minor point to add – our loan (and most new SOFR-based ones I believe) are on 6 month reset schedules, so our caps won’t last quite as long.
Great rate! So you have a 5/6, not a 5/1. I wrote about 5/5 ARMs in the past.
Resetting every six months could be To your benefit as interest rates come down here
I always enjoyed these ARM vs FIXED posts.
I currently have two 10yr ARMs. Both jumbos.
One on my primary at 2.25% (purchased last summer). This one is larger. Was offered a 30yr fixed at 2.75% at the time.
One on a hybrid vacation/ rental at 3.00%. This will reset 18 months before the primary ARM does.
ARMs were a no brainer for me. To your point, nothing happens in a vacuum.
If rates/ inflation somehow continue at this pace for 8 years then I’ve killed it in property value. Both homes are already up considerably.
Let’s game out three possible scenarios:
Base case: Pay off the 3.00% loan before or shortly after it adjusts. Even if the rate on my primary goes up 18 months after that, my monthly housing payment is less than now since I would have only one mortgage.
Bull case: Pay off both before they reset or pay off vacation/ rental and upgrade primary to bigger/ nicer home. Either way never see either ARM adjust and I saved a ton on mortgage interest.
Bear case: Rates skyrocket. Can’t pay off 3.00% property before it adjusts and monthly housing costs becomes untenable. Sell vacation/ rental property and take portion of proceeds to pay down primary mortgage so new monthly payment is manageable.
I think a combination of fear and ignorance is why so many people have 30yr fixed. I’m not saying they are wrong, but I believe people do not fully understand how ARMs work. Mortgage brokers also fear monger and push 30yr as fears are higher.
Bottom line everyone’s situation/ risk tolerance is difference. I totally get people paying for “peace of mind” but I’m confident I will likely come out ahead financially 10 years from now.
Yes, it is logical for mortgage brokers to push 30 year fixed rate mortgages because they are more profitable. Maybe my pulse will make a difference and help people save money on their mortgage interest expense. But I still think only a tiny minority Welco the arm route, No matter how much logic I share.
chart that shows the spread between 30yr fixed vs 5/1 ARM
https://darrowwealthmanagement.com/wp-content/uploads/2022/05/Fixed-vs-ARM-Mortgage-Rates-1.png
ARMs are now attractive once more in 2022 ..
I also got a 7/1 ARM at 4% for my second home a few months ago .. but all my purchases last year had 30yr fixed mortgage
The spread is invaluable context in this thread. I love this debate, and the net of the analysis places the ARM as the clear winner in the vast majority of cases. That said, without the spread analysis it’s hard to say. We bought in 9/2020, and I was all-in for the ARM in theory, but the spread was under 0.25 across 5 lenders. So we took a 2.625% 30-yr fixed on a jumbo, but I feel like I missed out bc I didn’t have a 50 bps spread that would have put me in the ARM
As stated in last paragraph, ARM is the best vehicle for you since you are focused on pre-paying the loan within 10-15 years.
30-yr fixed is the right vehicle for those folks who want to maximize leverage & accumulate multiple properties w/o having to balance the extra interest rate risk after 7 years.
Also the spread between ARM vs 30-fixed was almost zero a year ago, when 30-yr fixed rate bottomed at 2.5%. Its a no-brainer to choose 30yr fixed when the spread approaches zero.
Was the spread zero? I don’t think so. But maybe I wasn’t looking intently enough because I already locked in 2.125% when the 30-year was at 2.875% at that moment in time in June 2020.
What type of loan do you have and how many properties do you own? I hope more people can share what they were actually doing and their real estate portfolio. It provides better context. Thanks
It was for me in January 2021. In fact when the spread is zero at such low rates, they won’t even offer the ARM for obvious reasons.
Using this logic, a person would be foolish to pay the higher premiums for a gold or platinum health insurance plan. If you pencil it out it over a few years your making a suboptimal financial move. Why pay extra when you could buy a catastrophic plan for half the price. Your response has always been because you want piece of mind. Its the same thing with a 30 year vs. a ARM. People will pay more for piece of mind.
Indeed. That is consistent logic.
For me, paying more in mortgage interest expense is not as big of a deal. There are less variables to consider.
With health, there are an unknown number of variables that could happen, especially with two young children developing into their own. Therefore, I’m willing to pay up for a gold plan for better peace of mind. Healthcare is no longer just for me, but for three other people I love. I found it easier to pay more when it’s on other people.
That’s why personal finance is so personal. I’ve got 2 mortgages in my life. Both were 15 years even though I knew I’d pay them off in 7 years at most. I paid for peace of mind. Health insurance to me is a racket. I buy catastrophic plans with 5k out of pocket. I know the worst case scenario just as you do with your ARM”s. Doesn’t matter if it’s my kid or wife. 5k max. Just as you take the love and emotions out of your mortgages,I take the same out of health insurance.
FYI, I pay $3600 a year per person.
That doesn’t seem possible
Another reason to get a gold or platinum plan is the service. There are so many stories where the person with the disaster insurance is ignored over the person with a better plan. It’s just human nature to treat people a little bit better who are more “qualified.“ This is something that is worth a lot during the time of health duress.
I think you are confusing the current high deductible plans with those of pre-Obamacare. I have a HDHP, it is with a name brand insurance company with basically the same back ends as their standard plans. The difference is like my home and car insurances, I just pay a higher deductible in the beginning, therefore I save on rates because it takes a larger bill for me to use the benefit.
The hesitation with ARMs comes from a fear of payment hike. No one wants to build in a rise in their cost of living.
For a primary residence purchase, I would pick the mortgage with the lowest payment (adjustable or fixed) and then refinance to a 20-year within 5 years. In my experience, the 20-year meets or beats any ARM offering in any rate environment.
If more people knew there is a 2% max increase after the intro fixed duration period is over followed by another 1% max hike per year until an ultimate max hike, would that make people feel better? I just don’t think most people understand this.
It might. You’re right in saying that most people don’t understand the way ARMs work. I would add that most people CAN’T understand the way ARMs work, at least, not easily. God knows the lender isn’t going to take the time to explain it; they’ll probably push unknowing borrowers into a different direction.
The average person is not as interested in finance as you and me.
Sam –
Thank you for explaining how the rate hikes work for ARMs. I never knew this. We’ve always stayed away from ARMs due to fear of increasing monthly mortgage payments due to an increased interest rate. I never took into account the years spent paying down your loan amount before the rate increased. Not did I realize the rate has a limit on its increase. I guess ignorance really is not bliss.
For our SoCal current primary residence purchased in 1987, we started off with a 30 fixed. We wanted a 15 year fixed due to the high interest rates at the time, but we did not qualify for a 15 year loan. We were eventually able to refinance to a 15 year loan about three years later.
In 2005 near the absolute height of the housing market, a few months before paying off the 15 year mortgage on our SoCal current primary residence, we purchased a “vacation” SFR in the heartland using a 30 year loan with no down payment We didn’t have the spare cash laying around and we did not want to make a withdrawal from my work 401k for the down payment. Thus we had an 80% first with a 20% second. The high interest rate on that 20% second was a pain in my you know what, but we didn’t have the spare $15k to just pay it off.
A few years later in 2010, we purchased second SFR in the heartland, just a half mile up the street from our “vacation” house. This time we remortgaged our SoCal current primary residence to pay off the first and second mortgages of the “vacation” house and purchase the second SFR with cash. I was SO happy to finally be rid of that horrendous second mortgage! It was quite the eye-opener that we could buy two SFRs in the heartland for less than half the cost of our SoCal home. Due to a sequence of deaths in the family, we sold this second heartland SFR in 2017 (at a personal capital loss of $13k). Our SoCal current primary residence mortgage (interest rate 3.125%) will be paid off in December 2026.
In March 2012 near the absolute bottom of the housing market, we purchased a rental property less than a mile away from our our SoCal current primary residence using a 30 year fixed mortgage (interest rate 3.875%). This time we did take a withdrawal from my work 401k for the down payment since we were caught a little bit short on the necessary cash. Yet another case of financial ignorance: we did not realize lenders wanted 25% down for a non owner occupied property rather than the 20% we had saved up. *SIGH* Starting with January 2021, we have been making a large lump sum payment at the beginning of the year to pay down our principle balance. Our rental property mortgage will be paid off in January 2027.
I think we decided not to make extra payments on our SoCal current primary residence mortgage because I didn’t want to be in the situation – again! – where the mortgage was about to be paid off and we decide to leverage our home (!) to purchase additional properties. LOL
I do not have a good explanation for not refinancing to lower rates / shorter terms other than we are old, decrepit, lazy and our Credit Union’s loan underwriting process for non W-2 earners is a real pain. Also, the last time I looked into it, I think they don’t even do financing for non owner occupied property anymore.
Oh, re: Do you think there’s a correlation between financial knowledge and one’s views against ARMs? Based upon my own personal experience: YES!
Lots of valid points Sam especially on the rate cap for ARMs! There are always so many things to take into consideration including one’s own situation since the rates we get depend on our own individual circumstances. And sounds like your decision is working out just fine!
For somebody planning to keep a second home long-term, Would be interesting to see an amortization calculator comparison on a 30 year fixed rate versus 7/1 arm 10/1 if you have day a set amount you want to pay a month. For example, Say I’m willing to put 250 K down to $1.2 million home. In addition I’m willing to spend $5000 a month no matter what loan product it is and the additional amount would be put towards principal. I’m curious what would offer a quicker payoff timeframe amongst the different loan amounts for somebody looking to payoff the quickest, and how the principle changes over time.
Worth running the numbers and sharing what you find out! Taking out a 30-year and then paying down extra principal a month is also a good strategy to shorten the payoff period and not pay too much interest overall.
Solid arguments. We tend to fear or discredit what we don’t know. And I agree inflation and interest rates won’t stay at this elevated level for more than three years. By this time in 2023, inflation and mortgage rates will be down again.
You would have to get really unlucky by taking out an ARM in 2015, not refinance at any point since 2017 despite rates plummeting lower, having the rate reset in 2022, pay a 2% higher rate, and have inflation/rates still be at this level in 2023, 2024, to FINALLY start not saving as much in 2025.
But if you bought in 2015, your property is likely up at least 50%.
Thanks for addressing a point that I’ve made in previous articles as comments (you haven’t replied though). As I have mentioned, I took out my 5/1 ARM in 2016, at 3%. in Feb 2021, it dropped to 2.625%. In Feb 2022, it went up to 3%. In Feb 2023, I’m fully expecting it to go to 5%. Do I regret not refinancing in Aug 2021? Not really, because I would have been hesitant to pay all the closing costs.
I just wish my basement finishing project would get done so I wouldn’t have this need to keep cash available and I could invest it (I just got 24 month no interest financing on the wet bar, so that’s cash I won’t need to keep around) since my builder only asks for money as the project progresses.
What was your comment I hadn’t responded to and what was your question? Lots to keep track after writing 2,500+ posts since 2009. Thx
Sorry, it looks like you are responding to my comments, but I am not getting the alerts. So let me look into that a bit.
Yoooo. My numbers are pretty much identical. 5/1 ARM Purchased in June 2016 @ 2.75%, 2021 went to 2.5% now at 2022 reset was 4.5%. Am I crying now?
No way.
When I first ran the numbers my breakeven point was year 12 and with one adjustment lower it’s probably more like 14 years at this point. I’ll be moving way before that date ever gets here.
I saved about $24k in interest over the lower rate and invested that during a big bull run.
There you go! And the interest rate my recent lower in 2023 or 2024 is ready to come back down. To break even point maybe even longer.