If you haven’t been paying attention, thanks to pandemic fears, the 30-year bond yield and the 10-year bond yield have reached all-time lows. And when Treasury bond yields hit all-time lows, mortgage rates follow suit.
In a strange way, I wish I still had a mortgage to refinance. In mid-2019, I locked in a 2.625% 7/1 ARM for no cost. If I could refinance the mortgage today, I probably could get at least 2.375% for no cost. Oh well.
For those of you smartly looking to refinance, do a cash-out refinance, or purchase a new property, I’m here to argue that an Adjustable Rate Mortgage (ARM) is better than a 30-year fixed-rate mortgage (FRM).
Why An ARM Is Better Than A FRM
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 ARM is better than an FRM if you want to save 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.
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:
- 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
- The Fed Governors all turn out to be the dumbest, most inept people on Earth
- 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
- Employment growth would need to be so strong that it causes the natural rate of unemployment to fall to 1-2%, 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.
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 is in 2020, your best value is to borrow at the deepest point of the inversion. In this case, the cheapest term to borrow is five years. However, basically, any duration between 3-10 years offers great value compared to borrowing at a higher rate with only a 3-month term.
3) Match the average length of stay. Some of you might be thinking that taking out a 5-10/1 ARM is too risky because 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 10 years, the data shows otherwise.
The average duration one lives in and owns a home is about 8.5 years. 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 21.5-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 (amortizing over 30 years) 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) 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) 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, usually another interest rate increase cap 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%.
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 is now on a cutting trend. 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. 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, not cash which is rapidly losing its purchasing power. Real estate is also a hedge against so many bad things in life.
6) Financial discipline. When you have 30 years to pay something off, the natural tendency is to pay it no attention. But when you have an ARM, 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 that 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 where 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.
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.
What Is Your Peace Of Mind Worth?
The more uncertainty and fear there is in the market, the lower mortgage interest rates will go as investors 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 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 and will likely appreciate over time.
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, can’t handle the reality of economics, don’t know your options, and don’t believe in yourself.
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