The ARM vs. Fixed Rate Mortgage Dilemma

Ramit of I Will Teach You To Be Rich had a recent entry wondering why consumers are opting for ARM at 5.8% when they can get a fixed rate 30-year amortized mortgage for 6.2%.

Quickly, for comparison, a $250,000 mortgage on a 30-year amortization will run you $1531.17 per month at a fixed rate of 6.2% while an ARM at the above rate will run $1466.88.  So, people opting for the ARM are only saving themselves $771 in payments per year, or less than 1/2 of a monthly payment.  Now, this doesn’t seem like a lot when you are buying 30-years of consistency and security when you go for the fixed rate mortgage.  However, it boils down to the question of whether you believe interest rates will continue to rise, or that they will fall slighlty.

30-years is a long time to try to predict interest rates. Historically, the United States prime lending rate averages out to 7.7% over the last 50-years (source: US Federal Reserve Data).  So, there is a chance that interest rates could rise above 6.2%…  This data includes the anomaly of the early 80s where rates spiked up to 18.9%, so the average is somewhat skewed to higher rates.  The one thing you can count on is that the banks have a large number of very intelligent economists working for them, and they are obviously betting that over 30-years, the banks will make enough money at 6.2% to cover their asses.  So, they’re betting

There is, however, significant research indicating that variable rate mortgages (ARMs) outperform fixed rate mortgages historically.  These articles look at historical data for the last 50-years.  Looking at my chart below (using data from the Bank of Canada and the US Federal Reserve), you can see that the prime lending rate is always lower than the 5-year fixed rate.  Also, 30-year mortgages are often padded (depending on economic conditions of course), so they would fall higher to ensure bank profits.  But, versus refinancing every 5-years, the ARM is always going to save you money, historically speaking. 

The bottom line is that if you can afford to weather some unexpected, short-term spikes in interest rates, then you should go for an ARM.  However, if you can’t take the heat, you are better off locking into a fixed rate mortgage. 

 

Ramit has also stated that he has consciously chosen not to invest in real estate.  However, many savvy investors and bloggers hold some real estate because it can be a good way to diversify ones portfolio.  Residential real estate is somewhat more volatile.  But, if the housing market does turn for the worse because people cannot afford their homes, that means the rental market will be hotter (although rents may decrease slightly, vacancies will decline).  This is a good time to invest in more income properties due to the low prices.  Commercial real estate can often be a very good investment also because the tenants tend to stay longer, and they actually make improvements to the property rather than causing decline as most renters do. 

If you are looking to diversify, but don’t want to invest directly in properties yourself, you should consider looking into REITs.  There are many local REITs that you could look up and make investments and there are also some publicly traded REIT funds such as iShares Exchange Traded Funds (USA) from Barclays.  The Canadian REIT Sector Index Fund has increased in value by 120% since 2002 and appears to still be on the increase.  This fund will be partially affected by property values, however, the paper value of the assets of a company are not the basis for stock performance.  The REITs tracked by this fund make their money off of rents and leases, and barring a significant depression in the economy, their income should remain fairly consistent in my opinion.

Some of the comments on Ramit’s post were interesting.  There seem to be many misunderstandings about real estate in the comments section.  One reader says there are more foreclosures now because people have made bad decisions.  I question the use of the word bad because although the decisions have not turned out well, they were most likely misinformed decisions.  There are a myriad of reasons a person could end up in foreclosure such as losing a job, interest rate increases, health issues, etc.  Also, because people are entering into high-ratio mortgages, the payments are much higher, and thus more difficult to afford.  There is also talk of whether houses are good investments.  Well, there are many ways to make money from owning a house.  Improving the house will increase its value, you can invest in real estate for rentals and earn money monthly, and in general, housing prices rise over time.  Yes, prices can decline, but on-average they increase.  Furthermore, compared to renting, you are able to build equity in the home, so that must be considered when looking into whether to rent or buy.

 

For some more information on ARMs, visit the Wikipedia entry here.

 

I post with WriteToMyBlog

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