If you're buying a home anytime soon, here's some contrarian advice: Don't take out a fixed-rate mortgage. If you do, you're likely to pay more than you need to.
Instead, it often makes more sense to choose a floating-rate note, also known as an adjustable-rate mortgage. Even on a small mortgage, over time you'll save thousands of dollars. If you use the extra cash to pay down the loan, you'll save even more.
Such loans come in and out of fashion for a couple of reasons, says Frank Nothaft, chief economist at Freddie Mac. When rates on fixed loans are perceived to be low, borrowers tend to shun ARMs. When the difference between fixed and floating rates is small, again people tend to shun ARMs.
Floating-rate notes are considered riskier than fixed-rate mortgages because the monthly payment can jump higher. A so-called one-year ARM typically will reset each year based on fluctuations in the interest rate on the one-year Treasury security or the interbank cost of borrowing known as Libor.
Other common ARMs reset each year after an initial fixed period of three, five or seven years. Fixed-rate mortgages do make sense for some people. For instance, if your budget is so tight that even a small increase in your monthly payment would break the bank, a fixed-rate mortgage makes sense. A fixed rate would also make sense if you will keep your new home for a long time, like 30 years.
But for many people, ARMs come out ahead. Those people need to close their ears to the deafening sound of the ARM naysayers, like one financial planner I heard from: "You have got to be kidding. I guess a bad idea never dies. Don't Americans ever learn?" I've withheld the name because I don't want to embarrass him.
It's true: Many people have been burned by ARMs. But as long as you are smart about it—more on that later—that financial adviser is wrong.
The main reason an adjustable rate will be cheaper is this: You almost certainly won't be in your new house or apartment for the next 30 years, the typical life of a fixed-rate mortgage. Most people move every eight to 10 years, says Scott Buchta, head of fixed-income strategy at New York-based brokerage firm Brean Capital LLC. And even if you do stay longer than that, your mortgage won't survive 30 years if you refinance at some point.
That's important because the main reason the rate on a 30-year, fixed mortgage is higher than floating rates is that the lender assumes you will take the full 30 years to pay it back. That puts the lender at risk of losing money on the loan if borrowing costs go up during that term. So the lender charges you more.
For that higher interest rate, you get a form of insurance: the security of knowing what your payments will be for the life of the loan. You can sleep better at night, knowing that if interest rates shoot higher, it won't hurt you. But if you close out the loan in, say, 10 years—by moving or refinancing—you've paid too much for that insurance, because you were paying as though you needed 30 years of it.
Here's an example of how much that can cost you. If you took out a 30-year mortgage in January 2003 the average fixed rate was 5.92%, according to Freddie Mac. Ten years of interest and principal payments on a $200,000 mortgage would have cost you $142,660. But if you went with a one-year ARM, which kicked off at 3.99%, according to Freddie Mac, after resetting each year the total cost would have been $119,181. That's a savings of $23,479.
Yes, the interest rate on the ARM jumped as high as 5.47% in that 10-year stretch—still lower than the rate you would have gotten if you had gone with a fixed mortgage—but it also fell as low as 2.76%. Rates for floating vs. fixed mortgages have followed a similar pattern since the widespread introduction of ARMs in the early 1980s.
The savings noted above could have been even higher. If you take the cash you save this way and put it toward paying down the principal, you'll save two ways: You will shorten the life of the loan. And when the rate is reset each year, the new payment is based on the principal outstanding at that point, not on the amount you originally borrowed, so whatever rate you are charged will be applied to a smaller amount of debt.
But what if interest rates suddenly shoot higher? Should you be worried that the rate of, say, 2.75% you can get on a one-year ARM will suddenly jump into the double digits at some point because of an inflation-fueled spike in interest rates like the one the U.S. experienced in the years around 1980? No. Because ARMs come with rate caps. Typically, an ARM has a lifetime cap of five or six percentage points above the initial rate, and a two-point limit for each reset.
The biggest caveat: Don't overreach. That's how a lot of people have gotten into trouble.
"People shouldn't use adjustables to stretch too far on a new purchase or refinancing," says Larry Luxenberg, a financial adviser in New City, N.Y. The lower initial interest rate on an ARM might tempt you to borrow more than you could with a fixed-rate mortgage—to stretch, as Mr. Luxenberg puts it—but that can backfire if an upward adjustment in the interest rate busts your monthly budget. If you can't handle an upward adjustment, you've borrowed too much.
There's a simple way to guard against that kind of trouble. Work out how much your housing budget is (excluding taxes and insurance) and how much that allows you to borrow at current fixed rates. Then borrow no more than that amount.