95% of Homebuyers May Be Making This Mistake
Part 7 of the Series: Empowering Homebuyers Through Education
Fixed rate loans are the most popular mortgage product by a staggering amount. In fact, according to the Mortgage Bankers Association (MBA) fixed rate loans accounted for over 95% of all loans originated in the last three months of 2016. Among the fixed rate products, the 30 year fixed rate mortgage is the most popular product by far.
While we don’t believe there is anything wrong with a 30 year product, we think it is worth asking yourself: How many things in your life stay the same for 30 years? If you’re like me or most Americans, the answer is most likely nothing!
To get a sense for why customers overwhelmingly choose this product, we asked recent and potential homebuyers why. Some of the most popular answers we received were:
- “Everyone in my family said they closed with a 30 year mortgage”
- “You mean there are other mortgage types besides a 30 year fixed rate?”
- “I’m risk averse, it seemed like the safest option available”
When we asked people about Adjustable Rate Mortgages (ARMs), here were the most popular responses:
- “I don’t understand them”
- “I’m nervous that rates are going to rise”
- “Aren’t those the products that caused the most recent financial collapse?”
- “My loan originator never even told me about ARMs”
The responses are representative of themes we consistently hear from homebuyers: lack of awareness, disdain for uncertainty and reliance on friends and family for advice.
Given this context, our objective for this article (in conjunction with our article, Fixed Rate or Adjustable Rate Mortgage? What you must know before you decide) is to empower you, the homebuyer with the knowledge of Adjustable Rate Mortgages so you can make an informed decision that allows you to better assess your risk tolerance and reduces your dependency on others to make a sound, independent decision.
To begin, in the history of mortgage lending in America, the average life of a loan is between 4 and 7 years. Therefore, a question that all borrowers should ask themselves is why should do I need a mortgage for 30 years if there is a high likelihood I will sell my home or refinance my mortgage in 4–7 years. If you don’t have a good answer to this question, then an ARM might be right for you.
ARMs come with lower interest rates than the 30 year mortgage. Thus, over the life of your loan, you will pay less in interest and more of your money will go to paying down principal.
The reason adjustable rate mortgages come with lower rates is that the lender does not have to factor in the risk that this loan will potentially be in existence for 30 years at the same interest rate. This is because ARMs come with a fixed rate for an initial period (typically ranging from 5–10 years) and then they adjust to market rates. Because of the adjustable rate feature, lenders bear less risk that a loan they originate today will be below the market rates in the future, so in exchange for that feature, you the consumer, get a lower interest rate.
Let’s look at a hypothetical scenario on a $300,000 loan to put things in perspective:
Assumptions:
- All factors in the two scenarios are the same except the product/rate
- 30 year fixed mortgage interest rate = 4.00%
- 7/1 ARM interest rate = 3.50%
- You stay in the loan for 7 years, which is the long end of the historical average
Under this scenario, if you were to finance your home with a 30 year fixed rate loan, you would pay $41,821.59 in principal and $78,487.07 in interest during that 7 year time frame.
In contrast, if you were to use a 7/1 ARM, you’d pay $44,866.08 in principal and only $68,293.18 in interest in that same 7 year time frame.
This means that by going with a 7/1 ARM, you’d contribute $3,044.49 more to principal and you would save $10,193.89 in interest payments!
If you choose to stay in the same loan for longer than 7 years, your rate and monthly payment can go up or down, but the upward adjustments are limited by a cap so you rate will never exceed a certain interest rate.
Moreover, if your position changes and you want to stay in the property for an extended period of time, you can always refinance into another ARM or a fixed rate loan at that time.
Adjustable Rate Mortgages, despite not being widely used, can be a very good product in the right scenario and we hope that this article along with our previous article, Fixed Rate or Adjustable Rate Mortgage? What you must know before you decide will serve as tools to help you make more informed financing decisions.
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