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.
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