An adjustable rate mortgage is better than a 30-year fixed-rate mortgage. With an adjustable-rate mortgage, you will likely save more money during the duration of your ownership. Even in a rising interest rate environment, an ARM will likely still save you money in the end.
I’ve been taking out an adjustable-rate mortgage since 2005. I will continue to do so because they are more efficient. Over the years, I’ve saved over $300,000 in mortgage interest expense as a result.
For those of you smartly looking to refinance, do a cash-out refinance, or purchase a new property, I’m here to argue why an adjustable-rate mortgage is better than a 30-year fixed-rate mortgage (FRM).
With ~95% of mortgage holders owning 30-year fixed-rate mortgages, I know I’m part of a small minority. However, if you spend several moments to read about my logic on why ARMs are better, you might just save more money going forward.
Why An Adjustable-Rate Mortgage Is Better Than A FRM
The main reason why an adjustable-rate mortgage is better is because it will likely save you money over the long run. I will back this up with logic, examples, and truth.
You know what sells? Fear.
For decades, lenders have used fear to get homeowners or potential homeowners into 30-year fixed-rate mortgages instead of adjustable-rate mortgages.
Lenders like to tell borrowers that if they don’t get a 30-year fixed mortgage, they’ll potentially face financial hardship when their ARM resets to a higher rate.
By pushing peace of mind, especially to first-time homebuyers, lenders get to earn more money off larger loans with longer durations that charge higher mortgage interest rates.
The thing is, lenders who push 30-year fixed-rate mortgages are either focused on their bottom line, not providing you the entire truth, or are simply ignorant about economics.
Here are the reasons why an adjustable-rate mortgage is better than a fixed-rate mortgage to save you money.
1) The long-term interest rate trend is down.
Interest rates have been coming down since the 1980s as the Federal Reserve has become more efficient in managing economic cycles.
The US has also become the world standard for sovereign assets through the purchase of US Treasury bonds. No country comes close to being as stable and as sovereign as US.
If countries like China would open up their capital account and let its citizens buy foreign assets, we would see a flood of capital head our way. I firmly expect foreigners to buy up U.S. real estate once the borders open and COVID subsides.
Of course, there is no guarantee that interest rates will stay down forever. But in order for interest rates to start a permanent upward trend, a combination of the following would need to occur:
How Mortgages Rates Could 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 would have to start printing endless amounts of money to stoke inflation or expectations of greater inflation. Ah hah! This happened in 2020 and 2021 to combat the global pandemic. As a result, inflation rates rose to 40-year highs. However, inflation is beginning to roll over again.
- The Fed Governors all turn out to be the dumbest, most inept people on Earth. Ah hah! Actually, if we understand how rich central bankers think, there are as fallible as the rest of us. They care about their legacy and they will sometimes tighten or loosen too much, creating big boom bust cycles.
- Our government would have to blow up our budget, which is possible if we decide to have medicare for all, free tuition, and wipe out all student loan debt without significantly raising taxes. Funny enough, President Biden announced his student loan forgiveness program, which will likely result in higher college tuition and a slight uptick in inflation.
- Employment growth would need to be so strong that it causes the natural rate of unemployment to fall to ~2%, which would, in turn, cause inflationary pressure.
- Globalization declines and Nationalism rises.
- The internet regresses and information flow slows
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. It is not a wise bet.
Yes, the Fed is starting another rate-hike cycle in 2022. Yes mortgage rates are up. However, mortgage rates don’t go up as much as the Fed Funds rate. Further, by the time your ARM adjusts, interest rates will probably revert back to its downward long-term trend.
Take a look at this historical chart below. Notice how the 10-year bond yield, the main determinant of mortgage rates, goes up less than half as much as the Fed Funds Rate. I expect things to be no different during this current rate-hike cycle.
What’s sad is despite the long-term downward trend in mortgage rates, the percentage of mortgages that are adjustable rate mortgages is still in the single digits only. In other words, millions of homeowners have been paying way more in mortgage interest than they needed to for decades. See the chart below.
2) A general upward sloping of the yield curve.
Due to the time value of money and inflation, the longer you borrow the higher your interest rate.
If you borrow money from me today to pay me back tomorrow, I won’t charge you interest. But, if you want to borrow money from me today, to pay back over the next 30 years, I’m going to charge you an interest rate above inflation to counteract inflation, make some money, and bake in some risk of default.
In other words, if you borrow at a 30-year fixed rate, you are borrowing at the most expensive part of the yield curve. When the yield curve inverted, as it was in 2018 and portions of 2020, your best value is to borrow at the deepest point of the inversion.
Take a look at the troughs of the yield curves in 2020. Where I circled is the duration where you should borrow to get the best value. However, basically, any duration between 3-10 years offers great value compared to borrowing at a higher rate with only a 3-month term.
In 2H2022, the yield curve has inverted, making an argument a recession is coming or is deepening. As a mortgage borrower, you get better value taking out a 30-year fixed-rate mortgage compared to taking out a one, two, or three-year ARM. However, it is unlikely the yield curve will stay inverted for more than a couple of years, which means there will be better value taking out an ARM again.
The thing is, the average 30-year fixed rate mortgage reached about 6% in 2H2022, which is 2% higher than the average 7/1 ARM. Hence, locking in a 6% 30-year fixed rate mortgage when mortgage rates are likely going to come down within a couple years is suboptimal.
3) Match the average length of stay.
Some of you might be thinking that taking out a 5-10/1 ARM is too risky. You plan to live in the property for much longer. If you think you’re going to live in your house for much longer than 20 years, the data shows otherwise.
The average duration one lives in and owns a home is about 11 years as of 2022. Therefore, taking out a 30-year fixed rate mortgage makes little sense. Not only will you be paying a higher interest rate, but you’ll also likely sell your home or maybe even pay off your mortgage in under 10 years.
A 19-year overestimation of ownership is a serious miscalculation based on the data at hand. Even if you end up owning your home for longer than a 10/1 ARM, you still have plenty of time to pay down more debt before the interest rate resets, refinance your mortgage, or set aside more money for potentially higher monthly payments.
If you plan to live in your house for 10 years, taking out a 10/1 ARM is the most ideal loan duration. A 10/1 ARM is usually between 0.25% – 0.5% cheaper than a 30-year fixed-rate mortgage.
Here’s what I did with some of my mortgages since 2003:
A) Took out a $435,000 mortgage in 2003, refinanced it multiple times to a lower rate, and paid it off in 2015
B) I then took out a $1,220,000 mortgage in 2005, refinanced it multiple times to a lower rate, and paid it off in 2017 by selling the property.
C) I then took out a $568,000 mortgage in 2007, got a free loan modification in 2010, and will pay off the remaining balance by 2023.
D) Took out a $990,000 mortgage in 2014, refinanced it in 2019, and will pay it off in 2027.
Based on my small sample set, I have an average mortgage duration of 13 years. The durations would be shorter if I had not refinanced all the mortgages and/or purchased cheaper homes. San Francisco is expensive!
4) Adjustable-rate mortgages have an interest rate cap.
I’m not sure whether it’s due to misinformation or fear-mongering by your lender or the media, but some people think that once the fixed period of the ARM is over that your interest rate will skyrocket. This just isn’t true.
There is a cap on the annual interest rate increase for the first year. Another cap usually for the second year, and a lifetime interest rate cap. Unless your lender is trying to swindle you, there is no endless increase in interest rate increases. Please double check by asking.
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%. You can read more about how high an ARM interest rate can reset here.
Don’t Forget Principal Gets Paid Down
But after five years, through normal and extra principal pay down, my mortgage was only about $704,000. Therefore, despite the interest rate increase to 4.5% for 1.5 months, my monthly payment hardly changed. After I refinanced my mortgage, my monthly payment went down from about $3,800 to $2,800.
Please know that an ARM doesn’t automatically reset higher either. The ARM rate is tied to an index + a margin. The index is usually the London Interbank Offer Rate (LIBOR). If LIBOR is lower during the year of the reset versus the year you took out your ARM, then your interest rate will actually be lower.
In my case, the Fed started raising rates since 2015, so I got caught in the upside since LIBOR follows the Fed Funds rate. However, the Fed cut its Fed Funds rate to 0% – 0.25%. If I took out a 5/1 ARM in 2010 and it reset in 2015, I would have paid the same interest rate for the first year. Good thing most of us with a high loan-to-value (LTV) ratio have the option to refinance when Treasury bond yields are low.
5) Heads you win, tails you also win with an ARM.
Let’s say you get completely unlucky after your 10/1 ARM expires and your mortgage rate goes up 2%. Further, you can’t refinance to a lower mortgage rate because Treasury bond yields are high. This could actually be fantastic news.
Things don’t happen in a vacuum. The 10-year Treasury yield is a reflection of inflation and demand expectations. If the 10-year yield, and therefore mortgage rates are rising, that means inflation is elevated or expectations for inflation are also rising.
Inflation increases in a strong economy due to a stronger labor market, rising wages, and higher demand for goods and services. When these things happen, the price of real estate also rises.
So what if inflation rises from 2% to 5%, causing your mortgage to reset from 3% to 6%? If your home is now inflating by 5%, and you have an 80% loan-to-value ratio, your cash on cash return has now gone up by 25%.
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. Cash will rapidly lose its purchasing power when inflation is high. Real estate is also a hedge against so many bad things in life.
6) Financial discipline is why an ARM is better than a 30-year fixed-rate mortgage.
When you have 30 years to pay something off, the natural tendency is to pay it no attention. But when you have an adjustable-rate mortgage, you are more aware and more motivated to pay down some debt before the fixed rate period is over.
Think of an ARM 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.
Building wealth is much easier when you have a target. An ARM gives you a great timeline target to reduce debt and build equity. The key to paying off debt and achieving financial freedom is discipline. An adjustable-rate mortgage is better than a 30-year fixed-rate mortgage because it will keep your ocused.
7) You’re not a helpless infant, you’re a Financial Samurai.
Before your adjustable-rate mortgage resets, you can do a number of things:
A) Pay down more principal to lower your future mortgage payments
B) Refinance your mortgage to a lower rate than the reset rate
D) Sell your property
E) Generate income from the property by renting out a room, a floor, or the entire property
F) Generate more income from your job or a side-hustle to pay for higher payments if worse comes to worst
G) Do nothing as the ARM resets to save time and potentially refinance fees
You have plenty of time and plenty of options to make a positive financial move before your ARM resets to a higher rate. If you just pay your mortgage payments as usual and pay no extra principal, you will have paid down roughly 11% of principal after five years.
Therefore, even if there is a rate increase, the monthly payment increase won’t be as bad as you think.
Why An Adjustable-Rate Mortgage Is Better: Peace Of Mind
The more uncertainty and fear there is in the market, usually, the lower mortgage interest rates will go. Investors tend to seek the safety of US Treasury bonds. The lower interest rates go, the higher demand there is for real estate. The higher the demand there is for real estate, the more equity you will build as prices rise.
Don’t listen to mortgage officers who push a 30-year fixed mortgage on you for peace of mind purposes. You know why an adjustable-rate mortgage is better. You should actually have less peace of mind knowing that you’re paying a higher interest rate than you need to.
Have an ARM that closely matches your duration of homeownership. It should make you feel great knowing that you’re paying the lowest interest rate possible to own an asset that provides utility. Over time, your home will likely appreciate as well.
If you really appreciate peace of mind, then quantify it.
Let’s say a 30-year fixed loan is currently around 4% vs. 2.625% for a 5/1 arm. Let’s say you borrow $1 million. $1 million X 1.375% (difference in the rate) = $13,750 more in interest expense you will have to pay every year for the length of ownership.
If you own the home for seven years, that’s $96,250 more in interest expense you would have paid for the comfort of having a 30-year fixed rate mortgage. Assuming interest rates stay the same over a 30-year period and you own the home for 30 years, you will have paid more than $300,000 more in interest than necessary.
In this example, is your peace of mind worth $96,250 – $300,000? Perhaps, but only if you’ve never read this post. And you can’t handle the reality of economics. Or you don’t know your options and don’t believe in yourself.
After reading this article, I hope you agree why an adjustable-rate mortgage is better than a 30-year fixed-rate mortgage. The next step is to refinance your mortgage and take advantage of all-time low mortgage rates.
Build More Wealth Through Real Estate
Real estate is my favorite way to achieving financial freedom because it is a tangible asset that is less volatile. Real estate also provides utility and generates income. It doesn’t lose 20%+ of its value overnight as do some stocks which miss earnings.
Interestingly, real estate is also one of the best performers in a rising interest rate environment. The reason why is because real estate rides the inflation wave and landlords can capture rising rents. For example, rents in the Sunbelt are surging as more people rent instead of buy.
Take a look at my two favorite real estate crowdfunding platforms. Both are free to sign up and explore.
Fundrise: My favorite platform for all investors to 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. For most people, investing in a diversified eREIT is the way to go.
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. Demographic trends are positive for 18-hour cities. If you have a lot more capital, you can build you own diversified real estate portfolio.
I’ve personally invested $810,000 in private real estate so far to diversify my holdings and earn more income passively. Thanks to my investments, I’ve received over $624,000 in distributions since 2017 and counting.
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