Over the past few years, the 30-year fixed has been the darling of the mortgage industry.
After all, you could get a fixed interest rate below 3% that would stay with you for 30 years.
In other words, an incredibly low rate that would never adjust as you paid off your home.
Of course, these low rates were subsidized via a massive Fed-led bond and MBS buying program, which has since come to an end.
Now that mortgage rates are 7% and possibly headed higher, it could be time to rethink your home loan.
The 30-Year Fixed Is No Longer on Sale
As noted, 30-year fixed mortgage rates were a screaming deal for many years, with the last few the best.
In fact, the 30-year fixed hit a record low 2.65% during the week ending January 7th, 2021.
Imagine having a fixed interest rate in the mid-2% range from now until the year 2050.
And imagine the value of the dollar eroding, while wages hopefully increase, making that fixed mortgage payment cheaper and cheaper over time.
Well, it’s not just a pipe dream for millions of American homeowners who in fact are living that reality.
This is one reason why homeowners aren’t selling, one potential insulating factor working against a massive housing crash.
Anyway, if you’re not one of these lucky homeowners, you might be wondering if the 30-year fixed is still the go-to mortgage of choice.
While it probably technically is, because it commands something like a 90% market share, it will cede some of that to other loan products if rates remain elevated.
Especially if mortgage rates hit 8% next. Even at their current levels, around 6.5%-7%, you might want to consider other options.
You Pay a Premium for a Fixed Interest Rate on Your Mortgage
If the 30-year fixed is no longer a good choice, what is? A scary adjustable-rate mortgage (ARM) that is subject to adjust even higher in the future?
Before we talk about ARMs, let’s consider the point of a fixed-rate mortgage. It’s to lock in a low interest rate.
When you elect to take out a 30-year fixed (or 15-year fixed) or any fixed-rate product, you pay a premium to do so.
Because the interest rate cannot change, the lender must charge a premium for that assurance.
As noted, there wasn’t much of a premium charged over the past few years, and in fact fixed mortgages priced below the price of ARMs.
But that’s no longer the case anymore, and the market has now normalized.
An ARM should be cheaper than a fixed-rate mortgage. And you should pay a premium for a fixed interest rate.
However, you need to question whether it makes sense to pay a premium for a 6-8% fixed interest rate.
Is a rate that high actually worth locking in for the next 30 years? Is there value there?
Adjustable-Rate Mortgages Can Be Significantly Cheaper
| Loan amount: $600,000 | 5/1 ARM | 30-Year Fixed |
| Interest rate | 5.5% | 7% |
| Monthly payment | $3,406.73 | $3,991.81 |
| Balance after month 60 | $554,763.92 | $564,789.89 |
Those who paid a premium to lock in a 30-year fixed rate in the 2-3% range were smart.
Those who consider doing so for a 6-8% interest rate might feel otherwise. That is, unless interest rates return to double-digits like they did in the 1980s and 1990s.
Assuming they don’t go absolutely haywire, an ARM such as the 5/1 ARM or 7/1 ARM could be a better alternative.
Instead of paying a premium, you get an initial discount for taking on the risk of an ARM.
That risk is a variable interest rate once the loan’s initial fixed-rate period comes to an end.
That means after 60 months or 84 months, assuming we’re talking about the 5/1 or 7/1 ARM.
If you believe interest rates will calm down over that period of time, or at least not rise much more, both products could provide a lot better value.
They can also provide options and flexibility as you observe mortgage rates over that period.
For example, you could go with a 5/1 ARM with a 5.5% rate instead of a 30-year fixed set at 7%.
That would save you roughly $600 per month for 60 months and result in a lower loan balance after that time.
If you made the higher 30-year fixed payment on your ARM for the first five years, the balance would be an even lower $514,463.15.
In the meantime, you could keep an eye on rates and pounce on any better opportunity that comes during that period.
If the 30-year fixed falls back to 5-6%, you can refinance out of your ARM and into a fixed loan.
If interest rates go up over those five years, you’d still likely be able to refinance into another ARM with a reduced rate. Or hope the fully-indexed rate isn’t much higher.
The one thing you’d want to be confident about is the ability to refinance in the future if need be.
If you’re not relatively certain you’d qualify for a mortgage in the future, a 30-year fixed priced at 7% could still be appealing, as unappealing as that sounds.
(photo: Sta. Charming)
