Interest rates increased for a sixth consecutive week but are still at generational lows around 4.00 percent for a 30-year fixed-rate mortgage (assuming you have excellent credit and 20 percent down payment). These low fixed rates allow homebuyers to lock in their housing expense for 30 years, so why would anyone consider an adjustable rate mortgage?
The highlight of interest rate news recently is Ben Bernanke making clear and public statements that the U.S. economy is improving at a pace that will require the Federal Reserve to being decreasing its purchase of mortgage securities (known as Quantitative Easing). This statement made interest rates pop up, but we have to keep things in perspective. Banks have enjoyed access to free money in the U.S. for several years and the game is coming to an end. With the crystal ball hinting that rates are on the rise, is there still room at the table for adjustable interest rate mortgage products at this time?
In general, I agree that a 30-year fixed-rate mortgage program is the better product today given the fact that interest rates will be rising over the next few years (barring any unforeseen economic events which delay this). However, not everyone fits neatly into this box.
An important question for a property buyer is how long do they plan on being in the home. If they think it is long-term, locking in their housing payment for 30 years makes sense. However, if someone thinks they might relocate within a few years, then from a cash flow perspective, an adjustable rate product would likely save them interest costs. Adjustable rate mortgages typically adjust annually and have an upper bound on how much they can increase (usually 1 percent). Rarely, if ever, would you start at a rate of 3.125 percent and in 12 months jump to 5 percent. Worse case is you would adjust up to 4.125 percent, so it’s a controlled increase that allows you to plan ahead if need be and budget accordingly.
Additionally, not all adjustable rate mortgage products are tied to the U.S. interest rate indices. Some, like mine, are tied to overseas indices like the LIBOR (London Interbank Overnight Rate). As you might guess from the name, this index is more sensitive to U.K. and European economic conditions. As bad as we think things have been in the U.S. since the Great Recession, it has been worse in most parts of Europe (recall the economic related riots in Greece, France, elsewhere and threats of debt default by countries like Spain, Italy, Ireland, etc.). At this time, the LIBOR continues to trend DOWN, not up. Maybe this will reverse soon, maybe not, but fingers crossed, my interest rate may actually go down when it resets in a few months, buying me another year of very cheap money.
The lesson here is to know what index an adjustable rate mortgage is tied to when you are shopping around for the best deal and then do a quick Google search to look at the trend of that index. That 60 seconds of time educating yourself could save you thousands of dollars in interest expense over the term of your mortgage.