Hello and welcome to Financial Face-off, a MarketWatch column where we help you weigh your financial decisions. Our columnist will give her verdict. Let us know if you think she’s right in the comments. And don’t hesitate to send us your suggestions for future Financial Face-off sections.
It’s difficult for home buyers. The median home price in the United States just crossed the $400,000 mark for the very first time (it’s at $407,600 to be exact, up 14.8% from a year ago, according to the last digits). On top of that, the cost of a 30-year fixed rate mortgage has also become much more expensive, with rates climbing to 5.51% from 2.88% a year ago.
Although there are signs that the real estate market is cooling, in competitive real estate markets cash offers and bidding wars were common until recently. Buyers are under pressure and they are making all sorts of concessions to get into homes, including skipping home inspections and foregoing other contingencies.
Taking out a variable rate mortgage is one strategy buyers have turned to in an attempt to (temporarily) reduce their monthly housing payment. This is becoming increasingly common, especially in expensive housing markets such as San Francisco and San Jose, Calif., and Bridgeport, Connecticut, according to CoreLogic.
Adjustable rate mortgages typically start with a lower than average interest rate and then “adjust” to a higher or lower rate (depending on how market-determined interest rates fluctuate at the time of the adjustment and other factors) after a defined period of time. A 5/1 variable rate mortgage (ARM), for example, changes its interest rate once a year after five years. Borrowers sometimes take out an adjustable rate mortgage if they think they will sell the home before the rate adjusts.
ARMs can be attractive because borrowers will initially have a lower monthly mortgage payment than they would with a traditional 30-year fixed rate mortgage. Currently, the introductory rate on a 5/1 ARM is 4.35% versus 5.51% for the 30-year fixed.
So which makes more sense, a variable rate mortgage or a fixed rate mortgage?
why is it important
“It’s amazing what people don’t know about mortgages,” says Ken Waltzer, director and co-founder of KCS Wealth Advisory in Los Angeles. He said he would ask clients considering ARMs to talk about two key numbers related to their loan — index and margin — and he would get blank stares in response.
In addition to understanding these numbers, borrowers considering an ARM first need to know how soon their payment could increase and – perhaps most importantly – whether they “will still be able to afford the monthly payment if the rate and payment go up to the maximums allowed under the loan agreement,” according to the Consumer Financial Protection Bureau, a federal consumer watchdog. (And remember, the mortgage payment is only part of your total housing costs; there’s also homeowners insurance and property taxes, and sometimes mortgage insurance and HOA fees. Homeownership to the property usually requires repair and maintenance costs as well.)
“You just have to be careful because there can be times when rates get really high and you’re paying 10% for a year or two,” Waltzer said. “You need to know if it’s possible.”
You may remember adjustable rate mortgages from the subprime mortgage foreclosure crisis that preceded the 2008 housing crash and the Great Recession. ARMs were popular with buyers looking to get a share of the housing boom (which turned out to be a bubble). Lending standards were looser in those days, leading to situations where lenders approved borrowers’ mortgages even though they couldn’t afford to pay them back, experts told MarketWatch. “In 2006, if you could fog up your mirror, you could get a loan,” Waltzer said. “Now you have to actually qualify.”
ARMs are less risky today, thanks in part to borrower protections established by the Dodd-Frank Act, according to Ricard Pochkhanawala, senior policy adviser at the National Center for Responsible Lending. Dodd-Frank required lenders to fully document a borrower’s income and assets and their ability to repay an ARM before the loan is issued, and he said borrowers must qualify for the loan based on of the fully indexed rate, and not on the introductory or “teaser” rate. ” interest rate.
Dodd-Frank was enacted over a decade ago, but I mention it because its protections are a valuable reminder that when it comes to getting a mortgage, it’s up to you, the borrower, to decide if the loan is right for you.
Before taking out an ARM, borrowers should ensure that they fully understand the specific details, including any interest rate caps or floors. That information is in the loan promissory note, which, unfortunately, most people don’t read, said Sarah B. Mancini, an attorney at the National Consumer Law Center. If you’re a first-time buyer, consider speaking with a HUD-certified housing counselor while you make this decision, Mancini suggested.
“It’s a crazy market and I think people feel compelled to do things that are really outside of what they can afford and feel comfortable with, and that’s not is not a recipe for success in homeownership,” Mancini told MarketWatch.
“A lot of people involved in this process have an incentive to push for the deal to go through, and so consumers have to protect their own interests. Real estate agents and loan officers all get a percentage of the price you pay for a house, so their incentive isn’t financially aligned with saying, “Go with a lower asking price.”
If we’ve learned anything from the pandemic, it’s that life is unpredictable, so is the economy and so are interest rates. My vote is to go with a fixed rate mortgage.
A fixed rate mortgage allows you to build your overall financial plan around a relatively predictable monthly housing payment, while ARMs introduce fluctuations.
“It’s easy to be lured into the lower ARM rate and a lot of people are probably saying, ‘What are the chances we’ll still be in this house 10 years from now when the rate becomes variable?’ But that exposes the buyer to interest rate risk that they might regret later,” said Ron Guay, certified financial planner at Rivermark Wealth Management in Sunnyvale, Calif.
“The flat rate takes the hassle out of monitoring the pricing environment and makes your most important expense a constant number in a world where everything else is more expensive next year (i.e. ‘inflation). You are protected against rate hikes and if rates go down (enough), you can refinance,” Guay said.
He added: “Any argument for ARM is based on nonsense that people can forecast higher rates and move to a fixed rate before them, which is just another form of market timing. (i.e. a losing game).”
Is my verdict the best for you?
On the other hand, an ARM may make sense if you plan to sell your home before the rate adjusts and you think interest rates are falling (meaning your loan will adjust to the decrease). Some people are comfortable making these kinds of bets, some are not.
“If you think there’s the slightest possibility that you’ll be staying in a home longer than about seven years, we generally don’t recommend a variable rate mortgage to clients,” said Christopher Lyman, Certified Financial Planner at Allied Financial. Advisors, LLC in Newtown, Pennsylvania.
“We’ve had a few customers over the past few months who are adamant they’ll be leaving this house in the next few years, so they’re taking the ARM knowing it’ll be the cheaper option if all goes to plan, but the concern we have for them is that life throws curveballs when you least expect it and if they’re stuck with that ARM and unable to refinance later than they signed up to pay much more interest over the life of the loan.
Here’s an example of how that might play out with a $440,000 loan, according to Lyman:
A 30-year fixed rate mortgage at 5.5% would mean a monthly payment of $2,500 and $460,000 in interest paid over the life of the loan.
A 30-year ARM would be 4.75% once in a while, then adjust to 6.75% in five years. Going forward, the rate can increase by a maximum of 1% per year for the duration of the loan with a maximum interest rate of 7.7%. This means an initial payment of $2,300 per month, then $2,800 in five years. In the sixth year, if he reaches the maximum rate of 7.7%, the monthly payment would be $3,000 per month. If we assume the above scenario and in the sixth year the interest rate remains at 7.7% for the remainder of the loan, the total interest paid over the term of the loan is $600,000 .
Let us know in the comments which option should win in this financial head-to-head. If you have ideas for future Financial Face-off sections, send me an e-mail.