Editor’s note: This is Part 1 of a two-part series. Read Part 2 here.
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. Parts two and three are the subject of next week’s article.
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 Oct. 8 of that year, I shopped for a $320,000 loan on a $400,000 single-family home in California to a borrower with excellent credit and adequate documented income. The market at that time offered this borrower a 30-year FRM at 6 percent and zero points, and a 3/1 ARM at 5.75 percent and zero points. The 5.75 percent rate held for only three years, after which the rate adjusted every year.
My conclusion at the time was that the 0.25 percent 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 five, seven and 10 years were priced between the FRM and the 3/1 ARM, making them even less attractive. …CONTINUED