Which is Better: 30-Year Fixed or 5-Year ARM

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After speaking at length with a client about "how much house can I afford", she asked a fairly common question that I thought could be addressed in public.

"What's better?  The 30-year fixed mortgage or the 5-year ARM?"

It's a fair question.  The answer comes from my Econ 004 professor (whose name escapes me):

"Like all things in economics, the answer is: 'It depends.'"

In other words, there is no right answer about "which is better".  It all depends on a homeowner's individual preference and their short- and long-term financial goals.

People who consider themselves to be "conservative" often default to the 30-year fixed mortgage because they believe it's the "conservative mortgage".  People in this category tend to place a premium on the emotional security of knowing that their mortgage will never change. 

There is nothing more calming for some people than the knowledge that their mortgage payment will not change for 30 years when their home is paid in full. 

I call this the "Sleep at Night" factor.

The major downside to the 30-year fixed, however, is that it puts the lender is in a terribly risky position.  The concept is called Time Risk.  The bank thinks, "30 years is a long time to tie up our money and what mortgage rates move higher in the future?  We committing to offering this low rate today!"

For this reason, 30-year fixed mortgages are usually much more expensive than shorter-term adjustable rate mortgages.  Lenders increase the long-term fixed mortgage interest rates to compensate themselves for the future risk of committing to an interest rate today.

Instead of defaulting to a 30-year fixed mortgage, a "conservative" homeowner should look at their overall financial picture and make realistic assumptions about their timeline for living in the house. 

If the moving trucks are scheduled to come back in 6 years, there is no real reason to pay extra to the lender for 30 years of Time Risk.  The Sleep at Night factor can be very expensive over time. 

The alternative is an adjustable rate mortgage.

With ARMs, the lender locks your interest rate for a period of time that may be as short as 6-months and as long and 10 years.  After that time period is over, the mortgage rate will adjust according to current market conditions. 

This way, the bank's Time Risk is dramatically reduced and when a bank's risk is reduced, their rates generally reduce, too.

So, like I said, the answer to the question of "which is better" depends on the homeowner's circumstances.  In an optimal scenario, a homeowner passes on as little Time Risk to the lender as possible without losing the emotional certainty of being able to get a good night's sleep.