But should you do an adjustable rate mortgage (ARM), which has an introductory fixed-rate period — usually five, seven or 10 years — and then periodically adjusts based on market conditions, or the more popular 30-year fixed-rate mortgage?
Most experts will tell you it's safer to go with the latter. However, after taking out several types of mortgages over the past 17 years, here's why I'm convinced that an ARM will likely save you more money:
There's certainly value in knowing that your interest rate will never go up over a 30-year period.
But the yield on the benchmark 10-year Treasury note is a key barometer for mortgage rates; when bond prices drop, interest rates rise. And bond yields have been declining since 1981.
It's very unlikely that the downward trend will change any time soon. In order for that to happen, investors would have to feel very optimistic about the economy (since quicker growth can lead to inflation, which then erodes the purchasing power of fixed-rate bonds and puts pressure on the Federal Reserve to raise interest rates).
Therefore, choosing an ARM is smarter because you'd be paying a lower interest rate (during the fixed-rate period) than a 30-year fixed-rate mortgage. And when the ARM eventually floats, you can expect interest rates to still remain low.
Too many people overestimate how long they're going to live in — and own — the same home. Given that the average homeownership tenure is 8.5 years, it makes no sense to do a 30-year fixed rate.
The more efficient route would be to do an ARM that matches a reasonable homeownership period. For example, if you plan to live in your house for eight to 10 years, taking out a 10/1 ARM (where the introductory rate lasts 10 years) is more cost-effective.
A 10/1 ARM is usually between 0.25% to 0.5% less expensive than a 30-year fixed-rate mortgage. Why? Because rates are lower when you borrow for a shorter period of time.
To illustrate, let's compare a 10/1 ARM with a 2.5% interest rate versus a 30-year fixed mortgage with a 3% interest rate.
With the 10/1 ARM, the borrower's monthly payment is $133 less, and after 10 years, the balance declines by 26% ($7,398 less). If the mortgage isn't paid off — or if the house isn't sold — by the 10th year, the owner can either refinance for a balance lower than 26% or let the ARM float.
One of the biggest fears perpetuated by proponents of the 30-year fixed mortgage is that once a fixed-rate period is over, the interest rate will shoot higher — making monthly payments unaffordable.
This simply isn't true because ARMs typically include several kinds of caps that control how much your interest rate can change at the end of each adjustment period. So unless your lender is trying to swindle you, there are no "endless" interest rate increases.
In 2014, for example, I got a 5/1 ARM with a 2.5% interest rate. In 2019, the highest it could reset to was 4.5% for one year. The ARM could reset by another 2% in 2020, all the way up to a maximum of 7.5%.
But of course, instead of allowing the ARM to reset, I refinanced my mortgage to a 7/1 ARM with a 2.6% interest rate, with no fees.
Think of an ARM as a money coach who pushes you stay on top of your finances.
Since you have a shorter timeline to reduce debt, you'll be more motivated to pay extra principal every month, quarter or year. The goal is lower your balance by as much as possible before your introductory fixed-rate period is over.
A 30-year fixed mortgage, on the other hand, is like your neighborhood gym: You hardly ever go, even though you know you should. When you have three decades to pay off debt, the natural tendency is to sit back and take your time.
Things don't happen in a vacuum. The 10-year Treasury yield is a reflection of inflation and economic growth predictions.
If yields and mortgage rates are rising, it probably means that inflation is elevated (or that it's expected to) because demand is increasing. So even if you have a higher mortgage rate, the value of your home will most likely be higher due to strong demand.
Given that the cost of homeownership 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, it is wise to own real assets such as real estate — instead of cash, which is rapidly losing its purchasing power.
Let's say you get unlucky and interest rates rise aggressively during the fixed-rate period of your ARM — and it stays high after your fixed-rate period expires.
Before your ARM floats, you can do a number of things:
- Pay down more principal to lower future mortgage payments
- Refinance your mortgage before the rate floats
- Recast your mortgage
- Sell your property
- Generate income by renting out a room, a floor or the entire property
Basically, you'll have plenty of time and options to make a smart financial move before your ARM resets to a higher rate.
This is one of the most important decisions you'll make when buying a home. Your decision will impact your monthly payment, how long it takes for you to pay off your mortgage, and how much interest you'll pay along the way.
But, whether you go with a 30-year fixed-rate mortgage or an ARM, you can at least be happy in knowing that you're taking advantage of record low mortgage rates. Just run the numbers carefully and be honest with your forecasts.
Sam Dogen worked in investment banking for 13 years before starting Financial Samurai, a personal finance website. He has been featured in Forbes, The Wall Street Journal, The Chicago Tribune and The L.A.Times. Sign up for his free weekly newsletter here.