Are Fixed Rates Safe And Adjustable Rate Mortgages Risky?

There is a general feeling that fixed rate mortgages are safer compared to adjustable rate mortgages.

Is that a real reflection of what’s at stake here?

The fear that homeowners feel come from the fear of the unknown. And this is mostly from the lack of understanding how ARMs work.

The truth behind fixed rate loans being safer is more geared towards the predictability of mortgage interest rates. And because no one can predict what happens to floating interest rates, there is always the perception of risks involved.

To really answer the question of whether one is more dangerous than the other, one has to understand how ARMs works.

Fixed rate mortgages (FRM) basically are home loans that have a fixed interest rates, resulting in fixed monthly payments over the course of the loan’s lifespan. So it is a type of loan that is easy to comprehend. The amortization schedule would show borrowers what to expect in the years ahead.

Adjustable rate mortgages (ARM) are home loans with interest rates that change during the term of the loan.

They basically consist of 2 phases.

The first initial phase of an ARM would have fixed rates for a pre-determined number of years. This can range anywhere from a single year to even as long as a decade.

To entice borrowers to take up these types of loans, lenders often offer very attractive rates during the initial period.

Once this phase expires, the interest rate for the mortgage switches to an adjustable rate that consist of an index rate plus a margin. Adding them up and rounding off to the nearest 1/8% would result in a fully indexed rate which would become the new interest rate on the loan facility.

The loan contract should specify which index rate to reference and what is the margin.

Some of the common indices uses for ARMs are treasury rates, prime rate, LIBOR, COFI, etc.

Because these indices fluctuate according to market conditions, their variable movements are what causes the interest rates of ARMs to move about and sometimes be very volatile.

But adjustments to mortgage rates have rules and conditions to adhere to.

For example, they might come with adjustment limits and interest rate caps. On top of that, it needs to follow the adjustment interval stipulated in the terms of the contract.

Let’s say the initial rate is 3% and after 2 years would revert to COFI plus 2% with an adjustment cap of 1% and maximum loan rate of 5%. Should COFI rise to 4% after 2 years, the fully indexed rate would be 6% (4% + 2%). But the adjustment cap would restrict the interest on the loan to 4%. And if there is no adjustment cap, the rate limit would still hold at 5%.

So it’s not as if one would be paying 6% today and waking up tomorrow starring at a 20% home loan bill.

A typical ARM might have an initial 5 year period of fixed rates, after which it converts to adjustable rates pegged to LIBOR plus a margin of 2% with an annual adjustment. The 5 year initial phase and annual refresh is what the industry labels as a 5/1 ARM.

Some other popular types of ARMs include the 3/1, 7/1 and 10/1.

Quoted rates for ARMs we see in newspapers and advertisement posters are initial rates, and are bad indications of how much a loan would actually cost. This is especially the case when the initial period is very short.

The biggest reason why there is a general perception that ARMs are more risky compared to FRMs is that regular homeowners don’t fully understand the dynamics of how variable rate home loans work.

That said. It is a fair reflection of something that is unpredictable. Stability is after all a better way to sleep at night.

Yet in the last decade, I’ve seen people who save more money from taking up ARMs outnumber those who took up FRMs by as much as 10-to-1.

This is because Fed rates are still so low and borrowers no longer hold onto a mortgage for a long time.

For fixed rate loans to be worthwhile, two conditions must exist.

  • One must hold onto the loan for the long term
  • Interest rates must be rising considerably throughout those years

These days, with low interest rates and homeowners ever so enthusiastic to refinance their mortgages, those who have been on fixed rates are turning out to be holding onto the short end of the stick.

This is not a short term observation, mind you. It has been a reality for over a decade.

I’ve seen home buyers taking on home loans with fixed rates as they were afraid of huge rate hikes… that never came. They ended up paying more than double the interest that ARM borrowers pay.

I guess that’s the price they are willing to pay for certainty and predictability.

Then there are those who had to sell their house dues to personal circumstances that suddenly arise. They would have saved thousands of dollars if they were on ARMs.

From a philosophical approach, FRMs might carry less risks. But as a standard, they also carry a higher price.

Anyway, even if you are on an ARM and suddenly feel fleeced by the bank, you can always call up your lender to refinance. And if they refuse, simply move the loan to another bank for a better rate.

Which one to choose really depends on your situation and personal tolerance to (un)predictability.

If you have no intention to relocate soon, then FRMs should be something to consider together ARMs.

But when you know for certain that you would be moving within a few years, then adjustable rates are usually the ones that would offer you the better deal.

Finally, if you calculated that ARM payment amounts would be stretching your household budget, then it is really not a good move to accept an ARM.

You don’t want a single spike to send you into delinquency and then default.

In such cases, FRMs would allow your to sleep better at night without having to wonder how interest rate fluctuations would affect your mortgage payments in the future.