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The 30-year fixed rate mortgage isn't such the no-brainer anymore.

After thoroughly thumping the interest rates on an equivalent 5-year ARM since December, the 30-year fixed has reclaimed its honor as "Most Expensive Mortgage Product".  The chart shows the difference as a half-percent, but real-life pricing puts it closer to 1.000%.

Right now, adjustable rate mortgages are very attractive to the right type of homeowner:

• First-time home buyer that expects to move within 7 years
• Has an existing 30-year fixed with plans to move in the next 7 years
• Active home buyer with a pattern of moving every 10 years or fewer

For people meeting the above criteria, locking in with a 30-year fixed rate mortgage may be plain overkill; an expensive insurance policy in the event you don't move or don't refinance within those first 7 years.

How expensive? Over the first 5 years, it's $3,660 per $100,000 borrowed.

Them's big numbers.

But just because ARMs may make financial sense -- psychologically -- they aren't for everyone.  Some folks lose sleep at the thought of a pending ARM adjustment and there is no amount of cash savings in the world that can make up for that kind of dyspepsia. If you fit that description, you know exactly what I'm talking about.

For everyone else, though, take a real good look at today's 5-year and 7-year ARMs. The pricing is attractive and the product could be a real money-saver for you over the long-term -- especially if you know you're not going to need your mortgage for more than 7 years or so.

If you're considering an adjustable-rate mortgage and want to know more about how they work or how they might work for you, anytime.  I'd be happy to help.

Homeowners with ARMs often assume that they have to remortgage when their home loan reaches the end of its fixed-rate period.  They automatically think their mortgage will adjust higher and that a new mortgage could provide payment relief.

Looking at the chart above, we can see how that type of thinking can be costly.

Read the rest of this entry »

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.

In an article titled "Fixed-rate loans means no surprises", the Washington Post suggests that fixed rate mortgages are the safest mortgage choice for homeowners.

This is not true. 

This article is another example of the mainstream media ignoring the finer points of mortgage planning and home equity management.

The author talks about financial "safety" which I measure in three ways:

1. How liquid are your assets?
2. How diversified are your assets?
3. What is your assets' expected rate of return?

Against those benchmarks, the 30-year fixed-rate mortgage fails terribly.

First, the 30-year fixed rate mortgage includes a principal paydown in every mortgage payment.  Those principal dollars are sourced from a checking or savings account that is available at a moment's notice.  Once applied to the mortgage, those dollars can only be re-accessed with a remortgage.

Second, as the 30-year fixed rate mortgage pays down, the homeowner's real estate investment increases by the amount of principal paid down.  Every dollar put towards the home is a dollar in housing.

And third, the money used to pay down principal has been taken from a bank account where it was earning interest and is now just "money on paper" where it gains nothing. 

Summarized, the 30-year fixed-rate mortgage renders a homeowner:

1. Less liquid
2. Less diversified
3. Less wealthy

In other words, the 30-year fixed-rate mortgage fails on all three "safety checks".  It's the opposite of financial safety.

That said, there is a certain class of homeowners for whom the 30-year fixed-rate mortgages is appropriate, but it's not suitable for all.  That's why blanket statements like "fixed rate mortgages are safe" are false.

Like every other mortgage product, a 30-year fixed-rate mortgage should selecting only as it fits into a homeowner's short- and long-term financial goals. 

Fixed-rate loans mean no surprises
Kirstin Downey
Washington Post, October 1, 2006

http://www.washingtonpost.com/wp-dyn/content/article/2006/09/29/AR2006092901101.html

Mortgage rates are virtually identical on 30-year fixed rat programs as they are for 3-year adjustable rate mortgages. 

It's an uncommon event, but it makes sense if we consider the state of the economy.

• Short-Term: Explosive growth with a potential for elevated inflation
• Long-Term: Steady growth with contained inflation

All things equal, short-term mortgage rates (i.e. ARMs) should be higher than long-term rates such as the 30-year fixed because (1) the inflation risks are higher in the short-term, and (2) the need for banks to earn a greater return is higher in the short-term, too.

But all things are not equal. 

We have to consider the risk of time to traders of mortgage mortgage bonds.  As in: the more time that passes between now and some point in the future, the more chance there is of something unexpected happening.

Unexpected.  That word choice cracks me up because everything in finance and economics is based upon what is expected, not what isn't.  It's when the unexpected happens that markets go bonkers.

And this is why rates are flat like Kansas today.  Time Risk -- or the acknowledgement that something could go wrong in the future -- is offsetting Inflation Risk and its a complete wash.

Lately, we've been in a rising interest rate environment. Fear is prompting Cincinnati homeowners with ARMS  to abandoned their adjustable-rate mortgages in favor of fixed-rate mortgages.

This could be a costly (and ill-timed) move for some of those homeowners, from Hyde Park to Mason.

Throughout periods of rising interest rates, lenders adjust their 30-year lending rates to reflect their projection of the long-term, average interest rate.  So, right now, refinancing households moving into fixed products are paying a handsome premium to do so.

To understand this logic, let's look at lending from a lender's perspective.

In lending to a homeowner for 30 years at a fixed rate, the lender is tying up its money for up to 30 years -- a quantifiable and known risk. "We don't know where rates will be for the next 30 years," the lender's economists will say, "but we think it will average x%."

With the projection in hand, the lender will then offer a homebuyer a slightly higher rate.

See, rather than under-price long-term fixed interest rates, the lender will choose to over-price. Lenders do not want to lose money on their investment in your home and 30 years is a long period of time to tie up funds.

As lenders are building in this long-term premium, homeowners are playing right into the psychology. Just like most people are frightened out of buying into a falling stock market, they are unlikely to take an ARM in a rising interest rate environment.

Homeowners choose fixed-rate products more often in rising interest environments and pay a premium to do so. Conversely, fixed loans are priced at a discount as interest rates come down. and, as expected, customers move to ARMs.

ARMs remain less expensive than fixed rate products on a monthly basis and homeowners should always remember that the mortgage is just one component of an overall portfolio.

Rising interest rate costs should be no more relevant to a homeowner than falling stock values in their portfolio or higher life insurance premiums -- it is simply a diversifiable risk that can be managed