The Cost of Fixed-rate (for lack of a better term) Security

The purported attraction of a fixed rate loan is security.  The lender assumes all the risk of changes in interest rates. That comfort comes at a price, however. On one hand, the borrower knows what his or her rate and payment will be for as much as thirty years. This price premium is, in effect, insurance that the borrower buys annually to have the lender assume the interest rate risk. Over the life of the loan, the cost of that insurance can add up:

Additionally, most (not you, of course) home owners that have owned a home for 10 years have a refi history that looks something like this:
  • 2002 - $300,000  30 year fixed 6.5% to lower monthly payment.
  • 2005 - $375000  20 year fixed 5,25% cash out at historically low rates.
  • 2010 - $350,000  20 year fixed 4.25% to lower rate and payment
  • 2013 - $327,000 15 year fixed 3.25% to save a ton of money in interest.
Average cost (whether out of pocket, out of equity or via a higher interest rate, I promise you, there's always a cost) per transaction: $4500 x 4 refis = $18,000.

Security? Only in an ideological sense.  

Whenever you find yourself on the side of the majority it's time to pause and reflect.  ~Mark Twain

Up next: Tough Love

Choosing Between Adjustable Rate and Fixed Rate Loans: The Best Financial Decision May Surprise You

The most basic decision home buyers and home owners have to make is whether to choose a fixed rate loan or an adjustable one. It isn’t easy to break through media hype and find real data on which to make a sound, objective decision about which type of loan would be better long-term. Unfortunately ARMs have been mostly prescribed as a way to afford a bigger home.  Dumbdumbdumbdumbdumb!  Whether it be borrowing or drinking, DO SO RESPONSIBLY!

A Short History (talking mortgages, not alcohol)
Americans have been regular customers of lenders selling fixed-rate loans since just after World War II. The fixed rate and payment provided a secure way for a growing middle class to achieve home ownership. Back then, adjustable rate loans as we know them today did not exist, so borrowers had little choice.

More recently, adjustable rate home loans have become widely available; however, they are still largely viewed with suspicion by a majority of borrowers. Adjustables make up only 15-25% of all home loans funded in any given period. Many of these are actually hybrid loans that have an initial fixed rate period of 3-10 years. Borrowers with hybrid loans generally plan to refinance out of the loan when the fixed period ends, so they are really choosing a “short-term” fixed rate loan rather than a true adjustable rate loan.

The “Problem” with Adjustables
The decision to choose an adjustable rate home loan over a fixed rate loan is a hard step to take for most people, for one reason: A fear of rising rates.  Many borrowers are old enough to remember, or have heard of, the Carter-era mortgage rates in the high teens, and most people think high inflation was to blame, and even though that's not how it works, this fear of the unknown motivates borrowers to choose the “safer” fixed rate alternative.
This decision is usually not in the best long-term interest of the borrower. It seems paradoxical, but in many cases choosing some sort of adjustable rate loan is actually the better financial decision. This is driven by two factors:
• The security of a fixed rate comes at a price (a higher rate compared to adjustable loans long-term).
• Over time, the interest rate risk of an adjustable rate loan diminishes, as the rises and falls of rates even out with the rhythms of the American economy.

Next, we'll look at the cost of fixed rate security to see how and why adjustable rate loans can outperform fixed rate loans over time.