Adjustable Rate Mortgages (ARMS) Vs Fixed Rate

Adjustable Rate Mortgages (ARMS) Vs Fixed Rate

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One of the most frequently asked questions when it comes to mortgages is: what is the cheaper option – fixed rate or an adjustable rate mortgages? When most homebuyers want to take out a loan, they go for the lowest rates available in the market. This of course makes sense, and at that point, 5-year adjustable rate mortgages sound like a good deal. However an ARM is only applicable for the first term and then the rate adjusts annually after that. For example, a 30-year ARM will be at fixed rate for the first five years, then after that, the rates adjust annually for the next 25. This will mean higher interest rates every year unless you plan to sell the house within those first five years.

Crunch the Numbers

As an example, let us take a loan for $300,000 with a down payment of 20% for a home that you intend to live for at least 10 years. You have a credit score of 760. This translates to a 3.25% interest rate over the next 5 years. Comparing that rate to a 30-year fixed rate that will be 3.875%, this rate does not appear to be all that bad. However, it is worth keeping in mind that a 15-year fixed mortgage is also at 3.25% per annum.

Looking at it from a financial point of view, a 5-year ARM and a 15-year fixed mortgage are the same in terms of interest expenditure. The only difference is that the 5 year ARM is then amortized over 30 years while the 15-year fixed is amortized in that shorter period. This translates to higher monthly payments for the 15-year mortgage.

Let’s take the rates used in the example to calculate the monthly expenditures. Note that these calculations exclude of taxes and insurance:

  • 15-year fixed payment: $1,686
  • 30-year fixed payment: $1,129 (this is $557 lower than the 15-year payment)
  • 5-year ARM payment: $1,044 (this is $642 lower than the 15-year payment; $85 lower than the 30-year payment)

Looking for a Better Option to ARMs

The example above shows that ARM is more expensive in the long-term for a buyer who intends to keep his home for longer than 5 years.

While the 15-year fixed mortgage will allow you to save $102,732 throughout the life of the loan, the repayment period is shorter which means you’ll need to pay more every month. This is in contrast to what would have been the case with the 30-year fixed repayment period. If you can comfortably fit this 15-year option into your budget, then go for it. If it is not possible, consider the 30-year option and make smaller amounts over a longer period, but try to pay a little extra every month. This reduces your repayment period as well as your interest expense.

Here’s a table for showing how making additional payments for a 30-year fixed mortgage can save you in the long run.

Pay this extra amount every month Your interest reduces by this much Reduce repayment period to this
$200 $45,510 7 Years, 4 Months.
$300 $59,781 9 Years, 9 Months.
$400 $70,949 11 Years, 8 Months.

By paying these extra amounts, you get to enjoy reduced interest expenses at the end of the loan’s life as well as a more flexible monthly expenditure. Seek the help of your lender in determining what the best repayment plan for your salary would be.

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