September 26, 2014 in Mortgages

Dear Dr. Don,
Which kind of loan is best: a variable or a fixed-rate mortgage?

Thank you,
— Kim Capital

View today’s lowest mortgage rates

Dear Kim,
I’m going to assume that you’re talking about only amortized loans where monthly payments go toward both interest expense and partial repayment of principal. Comparing an interest-only adjustable rate loan to an amortized fixed-rate loan is truly like comparing apples to oranges. So let’s not try to make such a comparison.

Which one is “best” depends on the direction of interest rates, your ability to pay higher monthly payments, and the length of time you stay in the house. Short-timers might be best suited for a variable-rate loan (also known as an adjustable-rate mortgage, or ARM) compared with others expecting to remain in a house for seven years or more.

A key concern is the direction of interest rates, or more specifically, the risk that they edge higher. Since rates have been at historic lows for some time, it is a good bet they move higher from here. The biggest worry is when a variable-rate loan becomes more costly than a fixed-rate loan.

If you can borrow at a 3 percent rate on an adjustable-rate loan or 4.25 percent on a fixed-rate loan, you’d be better off with the adjustable-rate loan if it remains below that fixed rate. As the variable rate heads higher, so will a monthly mortgage payment.

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There’s another benefit of the variable-rate loan to consider. The monthly mortgage payment on a $200,000 loan at 3 percent is $843.21. The monthly mortgage payment at 4.25 percent is $983.88. An advantage of the variable-rate loan is that you keep more than $140 a month initially. You could apply that to additional principal payments and reduce your overall interest expense, reducing the loan term. If the variable rate goes up, however, the capacity to apply those funds is diminished.

My personal preference for those expecting to be in a home for a relatively short time is for a hybrid mortgage carrying a fixed rate for a set number of years and later shifting to an adjustable-rate mortgage. A 5/1 ARM, for example, has a fixed rate for five years and then adjusts annually. You can select a fixed period that matches the time you expect to remain in the home. You might want to give yourself some breathing room with some extra time. For example you might go with a 7/1 ARM if you think you’ll be in the house for five years.

You’re likely to not see rates this low again for either variable- or fixed-rate loans. So lock in a fixed rate for at least the planned time in the house and avoid the risk of rising rates and more expensive monthly payments.

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