Mortgage borrowers having to choose between the different types of mortgages face a puzzle, which may be particularly perplexing today. Interest rates remain low by historical standards; the spread between fixed and adjustable rates remains large; but expectations are widespread that all rates will soon increase, unless the current collapse of stock prices causes rates to drop again. The challenge to borrowers who must make a type-of-mortgage decision in this environment is also a challenge to anyone presumptuous enough to offer them advice.
My response to that challenge has been to develop decision rules that indicate the circumstances under which each of the major mortgage types should be selected. I will illustrate with a hypothetical mortgage of $405,000 on a $450,000 single-family home to a high-credit score borrower at the competitive prices posted on my web site on Aug. 21. The interest rates cited are for loans carrying zero or close-to-zero origination fees. The numbers used are designed to provide readers with a feel for the magnitudes involved, but the decision rules are not dependent on them.
Fixed versus adjustable rate: In general, adjustable-rate mortgages are for borrowers who don’t expect to have their mortgage longer than 12 years. Beyond that, the cumulative effect of rate increases will probably outweigh the benefits of low rates in the early years. Taking an adjustable solely because of the lower initial payment is risky because of the potential for sizeable payment increases. It should be avoided, unless the borrower has solid reasons for expecting significant increases in future income.
30-year fixed-rate: The interest rate on my 30-year FRM on Aug. 21 was 3.625 percent, and the payment $1,847. The 30-year FRM is the default choice, meaning that it is the type of mortgage selected if there is no compelling reason to select another type, or if the borrower doesn’t care to invest any time in considering alternatives. Even if it is not the best choice, it won’t be a terrible choice.
15-year fixed-rate: The interest rate was 2.875 percent and the payment $2,773. Comparing the 15-year FRM with the 30-year FRM, the decision process is simple and straightforward. The payment on the 15 is 50 percent higher, but the borrower becomes debt-free in half the time. In my book, if you can afford the payment on the 15, you take it.
5/1 ARM: The initial rate is 2.50 percent and the payment $1,600. All ARMs have 30-year terms, the prefix numbers “5/1” indicate that the initial rate holds for five years, after which it adjusts every year. The rate on the 5/1 thus adjusts in months 61, 73, 84 and so on.
Borrowers who know they won’t be in their house for more than five years will minimize their costs by selecting the 5/1. The risk is that their tenure will turn out to be longer than five years, and interest rates escalate in the meantime. In the worst case, where the rate on the 5/1 increases by the maximum amount possible, the payment will increase by 24 percent to $1,983 in month 61, by another 21 percent to $2,395 in month 73, and by 9 percent to $2,608 in month 85.
Another useful measure is the total cost of the 5/1 over every period exceeding five years assuming the worst possible interest-rate escalation, compared to that of the 30-year FRM. The ARM has lower costs over five years but higher costs thereafter, which means that there must be a break-even period. It turns out to be eight years. If the borrower is out within eight years, the 5/1 ARM will save the borrower money relative to the 30-year FRM, even if interest rates explode The above suggests the following decision rule.
Take the 5/1 ARM if:
1.You are 80 percent sure you won’t have the mortgage more than five years, and,
2.You are 98 percent sure you won’t have the mortgage more than eight years, and,
3. If necessary, you will be able to manage a 24 percent increase in payment in month 61, a 29 percent increase in month 73, and a 9 percent increase in month 84.
Decision rules for 7/1 and 10/1 ARMs were developed in the same way.
For a 7/1 ARM, the initial rate is 2.625 percent and the payment $1,627. This loan should be selected if:
1.The 5/1 ARM is not a good choice, and,
2.You are 80 percent sure you won’t have the mortgage more than seven years, and,
3.You are 98 percent sure you won’t have the mortgage more than 10 years, and,
4.If necessary, you will be able to manage a 59 percent increase in payment in month 85.
For a 10/1 ARM, the initial rate is 3.0 percent and the payment $1,707. The decision rule is that the 10/1 ARM should be selected if:
1.The 5/1 and 7/1 ARMs are not good choices, and,
2.You are 80 percent sure you won’t have the mortgage more than 10 years, and,
3.You are 98 percent sure you won’t have the mortgage more than 12 years, and,
4. If necessary, you will be able to manage a 51 percent increase in payment in month 121.
I would be delighted to hear from anyone who makes a type-of-mortgage decision after reading this article.
The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.
