Ask Brian is a weekly column by Real Estate Expert Brian Kline. If you have questions on real estate investing, DIY, home buying/selling, or other housing inquiries please email your questions to [email protected].
Question from Violet: Hello Brian, at age 24, I consider myself to be a young homebuyer. Of course, I don’t have a crystal ball but I don’t think I’ll stay in my first house for very long. I’m recently out of college and just started working on my career a few months ago. Due to some favorable financial circumstances (no student loans and I live with a roommate), I’m already able to buy an entry level home. If things go the way I expect them to, I’ll be able to buy a bigger house in a few years.
I’ve been told by my older brother and others that I should take out an adjustable rate mortgage because I plan to sell my first house before the interest rate will increase. In fact, my brother bought his first home about six years ago. He tells me that he was able to buy a bigger house because the mortgage payments were lower with an adjustable mortgage. But my brother knows a lot more about technology than he does about real estate. What do you think?
Answer: Hi Violet. I’m glad you asked about adjustable rate mortgages (ARMs). Historically, ARMs have financially favored people that are not planning to stay in the home for at least seven years. Your question and logic make good sense because most real estate agents will tell you that the typical homebuyer only stays in a home for five to seven years before moving on. More specifically, first-time homebuyers are likely to get a "starter" home for a few years and then move up to a larger one as their income and/or family expands. There are other reasons why buyers prefer adjustable rates. There are times when the slightly lower introductory rate for an ARM makes the difference if a person can qualify for a loan or not. There is also your brother’s reason for wanting a bigger house. And there are times when people know that they will be refinancing the mortgage in a few years, so they take advantage of the short term savings until then.
Violet, it certainly won’t hurt for you to check out an ARM. Unfortunately, I don’t think you’ll find these to be a good deal in 2020 compared to past years. Because fixed rate mortgages currently have such low interest rates, many lenders are actually discouraging ARMs. They are doing that by setting adjustable introductory rates higher than fixed rates. The reality is that fixed rates are currently lower than adjustable rates. Even if you won’t be closing the purchase for a month or two, the foreseeable trend is that fixed mortgages will remain close to the lows they are currently at, while adjustable introductory rates are likely to increase.
Today’s ARMs are not market-driven. Lenders are intentionally raising the introductory rates. To understand why, you need to understand the basic working of an adjustable mortgage. ARMs begin with a set interest rate for a specified period of time and then the rate is adjusted periodically. The key to knowing how an ARM will adjust is in the name. A 5/1 ARM means the introductory rate is set for five years and then adjusts annually in most cases. Common ARM terms have introductory rate periods of 3, 5, 7, or 10 years.
The logic of lenders is that because fixed rates are likely to remain low, anyone with a low interest rate ARM will take out a fixed mortgage at the end of the adjustable introductory period. The introductory offer will not entice buyers to remain when the adjustment goes up. In almost all cases, these same lenders also offer fixed rate mortgages. Lenders are thinking that once they get buyers into these very low fixed rate mortgages, the lender will be able to keep many of the mortgages on their accounting books when interest rates inevitably begin going up. Because refinancing into a higher interest rate isn’t desirable, some borrowers may stay with the same lender until the mortgage is paid in full, 30 years down the road.
Something to always include in these calculations is the cost to refinance an existing home or take out a new loan for another home. Closing costs always come into play with a new loan (including refinancing) and that cost is typically 3% to 5% of the mortgage amount.
Violet, every lender is different, so it's worth getting all the information. But if you're buying soon, you'll probably save money by choosing a fixed rate mortgage.
Does anyone have a different opinion or thought? Please comment.
Our weekly Ask Brian column welcomes questions from readers of all experience levels with residential real estate. Please email your questions or inquiries to [email protected].