All Mortgages Are Adjustable

There are many different kinds of mortgages out there, with different terms and conditions. One way of classifying mortgages is by whether they're fixed or adjustable.

With a fixed rate mortgage, the interest rate remains constant for the entire life of the loan, usually 30 years. For example, you might have a 30-year loan fixed at a 6.5% interest rate. Fixed rate mortgages usually have higher interest rates than the initial rate on adjustable mortgages, in exchange for the certainty they provide.

With an adjustable rate mortgage (or ARM), the interest rate remains constant for a specified period of time, then adjusts periodically to reflect current interest rates. For example, you might have a 5/1 ARM with an initial rate of 6%. This means that the interest rate will be 6% for the first 5 years, then adjust every 1 year for the remainder of the loan term, typically 30 years. Adjustable mortgages usually have lower initial interest rates than fixed mortgages, but are less predictable because rates can go either up or down within certain limits.

There is no fixed vs. adjustable

Which is better, a fixed mortgage or an adjustable mortgage? Actually, all mortgages can be thought of as adjustable mortgages. For example, a traditional 30-year fixed rate mortgage can be thought of as a 30/1 ARM. In other words, the interest rate is fixed for the first 30 years, then adjusts every 1 year thereafter for the remainder of the loan term (although the remainder of the loan term happens to be nothing).

The reason I think of mortgages this way is because it makes it easier to set up an apples-to-apples comparison of fixed and adjustable mortgages. Let's consider a 5/1 ARM vs. a 30/1 ARM (i.e., a 30-year fixed mortgage).

There are two differences between a 5/1 ARM and a 30/1 ARM: (1) the initial interest rate, and (2) how long the initial interest rate is fixed. To really know for sure which is better, we'd have to know what interest rates are going to do in the future. If interest rates stay the same or drop, the 5/1 would generally be better, because you'd benefit from the lower initial interest rate, and then the rate would remain the same or lower. If interest rates go up, the 30/1 would generally be better in the long run, because your initial rate would be locked in for 30 years.

How long do you need to lock in your rate?

Every guarantee has a price. The longer you want to be sure that your rate won't go up, the longer you need to pay to lock it in. So how long do you need to pay to lock it in for? That depends on how long you plan to keep the mortgage.

People move every seven years on average. I don't have any statistics on how long the average person keeps their mortgage before moving or refinancing, but obviously it would have to be less than seven years. Less say it's every five years, just for the sake of having a number to work with. If you're only going to keep your mortgage for five years, why do you want to pay to lock it in for 30 years? You don't.

That's where the uncertainty comes in. Obviously it would be a lot easier if we knew exactly how long we were going to keep our mortgage, but the reality is that we don't know for sure when we're going to move, or when we're going to want to refinance to take cash out. All we can do is use our best judgment.

5/1 vs. 30/1

Let's look at an example. Let's say you plan to stay in your home for a few years, and you get a 5/1 ARM. And let's assume the worst happens—interest rates go up. For each of the first five years, you'll save money compared to a 30/1 ARM since you'll have a lower initial interest rate. So the first five years are golden, but let's say you're still in the same home after five years, and still on the same mortgage.

In the 6th year you'll have a higher interest rate with the 5/1 than you would with the 30/1. However, it will take some time for the higher interest after the 5th year to overcome the lower interest you enjoyed for the first five years. Maybe after eight years, you would have paid the same total amount of interest with either mortgage.

It's possible that a 30/1 mortgage would be more beneficial than a 5/1 mortgage in the long run, but not unless you keep your mortgage for a long time and interest rates go up. Otherwise, the 5/1 will likely be better for you. The bottom line is that a 5/1 definitely saves you money now, and may or may not save you money later, depending on your time frame and future interest rates. So when thinking about what kind of mortgage you want, throw out all that fixed vs. adjustable talk, and just focus on how long you need to lock in your initial rate.