One of the most
critical decisions mortgage shoppers must make is the type of mortgage
that best meets their needs. The importance of the decision has been
heightened by a post-crisis market in which price differences between
all categories of mortgages are unusually large.
The decision process can be divided into three parts: The first is whether to select an adjustable rate mortgage (ARM) or a fixed-rate mortgage (FRM). All ARMs today are 30 years, and in this article we compare them to a 30-year FRM. The second part of the decision process, for those who elect the FRM over the ARMs, is to select the term of the FRM. The third part is to decide whether or not to take an interest-only payment option.
FRM Versus ARM
FRMs offer
borrowers interest rate and payment stability. This is particularly
advantageous to borrowers who are not sure how long they will have their
mortgage, and who find the FRM payment affordable. ARMs offer borrowers
a lower interest rate and payment in the early years, which is
particularly advantageous to borrowers who know about how long they will
have their mortgage. ARMs also work for borrowers who require the lower
initial rate to make the initial payment affordable, and can handle the
risk of rising payments in the future.
Taking Account of Price Differences,
Borrowers should take account of the price differences between FRMs and
ARMs in deciding between them. If there is no or little price
difference, there is no good reason to select an ARM.
This was the case
when I last addressed the issue in 2006. On October 8 of that year, I
shopped for a $320,000 loan on a $400,000 single-family home in
My conclusion at
the time was that the .25% price difference between the FRM and the 3/1
ARM was not large enough to justify the price risk on the ARM – with the
possible exception of borrowers who confidently expected to be out of
their house within three years. ARMs with initial rate periods of 5, 7
and 10 years were priced between the FRM and the 3/1 ARM, making them
even less attractive.
Today, the price
differences are much larger and ARMs are correspondingly more
attractive. On January 8, 2010 I shopped the same loans described above.
The 30-year FRM was 5.125% and the 3/1, 5/1, 7/1 and 10/1 ARMs were 4%,
4.125%, 4.5% and 4.875%, respectively. The borrower taking the 3/1 ARM
rather than the FRM now saves 1.125% in rate rather than .25%. Note that
while market prices change every day, the price differences between FRMs
and ARMs are relatively stable in the short run.
ARM Borrowers With Short Time Horizons:
When the pricing is advantageous, the most logical candidate for an ARM
is the borrower who expects to be out of the house before the initial
rate period is over. While few borrowers can be certain about this –
life sometimes confounds our best plans -- the rate saving should
substantially outweigh the risk of being caught by a rate adjustment. If
you expect to be out within 3, 5, 7, or 10 years, select a 3/1, 5/1, 7/1
or 10/1 ARM, as the case may be.
ARM Borrowers Who Need the Lower Initial
Payment: A second reason to
select an ARM is the lower initial payment associated with the lower
initial rate. In some case, the borrower needs the ARM in order to meet
the lender’s underwriting requirements, which include maximum ratios of
mortgage payment and other expenses to borrower income. In other cases,
borrowers need the ARM to meet their own views of what constitutes an
affordable payment.
Borrowers who
select an ARM because they need the lower payment assume the risk of a
possible rate and payment increase at the end of the initial rate
period. Borrowers faced with this decision should ask themselves "Is
this a risk worth taking," and "can I afford to take it?"
The best way I know to deal with these questions is by determining what
will happen to the rate and payment on the ARM if market interest rates
change in ways that the borrower specifies. This "scenario analysis"
provides a measure of the risk if rates increase, and the benefit if
they don’t. It also allows borrowers to determine the extent to which
they can reduce the risk on the ARM by making the larger payment that
they would have made had they selected the FRM.
To do a scenario
analysis, you must know all the features of the ARM that affect future
rates and payments: the rate index used by the ARM, its current value,
the margin that is added to the index at a rate adjustment, rate
adjustment caps, and the lifetime maximum rate, You should have this
information anyway, otherwise, you don’t know whether you have found the
best deal on your ARM.
Readers who want to
do a scenario analysis on an ARM will find an explanation of how to do
it, with an example, at
Choosing
Between Fixed and Adjustable Rate Mortgages.
Selecting Among Different FRMs
In today's market,
the price differences between FRMs of different term are also unusually
large. On January 8, the rates for prime borrowers on 40,30, 25, 20, 15
and 10-year terms were, respectively, about 5.625%, 5/125%, 5.125%,
4.625, 4.5% and 4.25%. These differences largely reflect the increased
importance lenders now attach to borrower equity as their protection
against default. With home prices no longer rising, the faster pay-down
of loan balances on shorter-term mortgages has enhanced value. Lenders
will cut the price if you commit to paying down the balance faster.
Selecting the term
is in a sense a judgment by the borrower of the relative importance of
the present and the future. A longer term has a lower payment, which
favors the present, but a slower pay-down of the loan balance, which is
burdensome in the future. By pricing short-term loans lower, the market
encourages borrowers to favor the future, but this runs against the very
powerful tendency of most borrowers to focus on the present. While
clearly the payment must be affordable, many borrowers could afford more
but give the future a low priority..
The price of being
fixated on the present can be high. Lets take the extreme case of a
10-year versus a 40-year term. On a $100,000 loan, the payments are $524
and $1,024, almost 2 to 1. The borrower taking the 40-year saves $500 a
month in payment, or about $30,000 over the first 5 years. But at the
end of the 5 years, that borrower will owe $96,161 compared to only
$55,282 owed by the borrower who took the 10-year. The difference in
balances is $40,878 compared to the $30,000 difference in payments. The
larger difference in balance is due entirely to the lower rate on the
10-year. The borrower with the 40 paid $10,878 more in interest.
Some borrowers who
can afford the higher payment on a shorter term select a longer term
with the intention of investing the difference in cash flow. This is a
really dumb idea, even for a borrower who has the iron discipline
required to execute it. The pitfall is that, because of the higher
interest rate on the longer term loan, the return the borrower needs to
earn on the cash flow to come out ahead is just too high.
For example, if the
borrower selects the 30 at 5.125% rather than the 15 at 4.5%, he has to
earn 6.73% over the 15 years just to break even. If the loan is paid off
in 10 years, the breakeven rate is 8.12 %. And over 5 years, it is
12.35%. I don’t recommend this strategy.
Selecting an Interest-Only Payment Option
A mortgage is
“interest only” (IO) if the required payment for a specified period,
usually 5 to 10 years, consists only of the interest, though borrowers
have the right to pay more if they want to. The option to pay interest
only carries a price, relative to the price of the identical mortgage
without the option. The price is higher than it was before the financial
crisis, reflecting the heightened importance lenders today attach to
balance reduction as a way of reducing default risk.
On a prime loan
with 20% down, ARM borrowers pay a rate about .375% higher for a loan
with an IO option. On a 30-year FRM, the rate is about .5% higher. If
the loan is a cash-out refinance, the price difference is more like
.75%. And when the loan is on an investment property, it rises to 1%.
A tutorial on my
web site identifies 6 reasons borrowers might have for selecting a loan
with an IO payment option. I don’t recommend doing it to invest the cash
flow savings, for the same reason I wouldn’t select a longer term.
Because of the higher interest rate on the IO, the return you need to
earn on the cash flow to come out ahead is too high. Neither is this the
time to use an IO to stretch the amount of house you can buy, or to
finance a quick in-and-out transaction.
Borrowers with
fluctuating incomes who attach a high value to the flexibility the IO
mortgage gives them may find the IO price worth paying. When their
finances are tight, they can make the IO payment, and when they are
flush they can add a substantial payment to principal. Such borrowers
must be disciplined enough to make the payment to principal when they
aren’t obliged to.
Another group of
borrowers who may find an IO worth the price are those forced to close
on a house purchase before their existing house is sold, and want to use
the proceeds of the sale, when it occurs, to reduce the payment on the
new mortgage. IOs are the only mortgages on which a payment that reduces
the balance results in a lower required payment the very next month.
However, not all IOs work this way, on some the payment doesn't change
until the anniversary month, and on others it doesn’t change until the
end of the IO period. Anyone contemplating an IO in order to obtain an
immediate payment adjustment feature, needs to inquire about this. Note:
Get it in writing!