In today's market, financing a home purchase does not need to be complicated or confusing. The angst of selecting the "right" type of mortgage can be simplified with this Rule of Thumb:
If the loan amount is $417,000 or less, then select a 30 Year Fixed Rate Mortgage (FRM).
If the loan amount is greater than $417,000 then select a 10/1 Adjustable Rate Mortgage (ARM).
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Why?
The selection of a mortgage should be based on affordability and risk tolerance. Affordability is determined by the monthly mortgage payment. Risk tolerance is driven by interest rate exposure. The two are inversely related --- as the monthly mortgage payment decreases the interest rate exposure increases. For example, a 5/1 ARM has interest rate exposure (i.e. the interest rate changes after the 5th year) and a 30 Year FRM has no interest rate exposure (i.e. the rate never changes). As such, the initial interest rate on a 5/1 Adjustable Rate Mortgage (ARM) is lower than the interest rate on a 30 Year Fixed Rate Mortgage (FRM).
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On a loan amount of $417,000 or less, the interest rate spread between an Adjustable Rate Mortgage (ARM) and a Fixed Rate Mortgage (FRM) does not produce a substantial difference in the monthly mortgage payment. Since the Borrower does not receive sufficient compensation for interest rate exposure; the Borrower should forgo an ARM and finance with a FRM. Of course, there are exceptions to this rule. If the Borrower intends to sell his/her house (or refinance) within 5 years, then the Borrower should select a 5/1 ARM. Why? Because a) the 5/1 ARM’s monthly payment is lower than the 30 Year FRM’s monthly payment and b) the 5/1 ARM’s interest rate exposure is now a non-factor (i.e. the mortgage is paid off when the house is sold or refinanced).
On a loan amount above $417,000, the interest rate spread between an Adjustable Rate Mortgage (ARM) and a Fixed Rate Mortgage (FRM) does produce a substantial difference in the monthly mortgage payment. Since no one can predict the future, the 10/1 ARM offers an excellent hedge to affordability and risk tolerance. In today's market, the interest rate for a 10/1 ARM is approximately halfway between the interest rates for a 5/1 ARM and a 30 Year FRM. Plus, the 10/1 ARM offers ample protection against interest rate exposure (i.e. the interest rate does not change until the 11th year). Of course, the same previous exception applies to this rule. If the Borrower intends to sell his/her house (or refinance) within 5 years, then the Borrower should finance with a 5/1 ARM instead of the 10/1 ARM.
