Pick the wrong mortgage structure and your deal will fail. That’s right!
The right deal, team, and market and still, if you pick the wrong mortgage, the whole thing can go down the drain.
Recently, we have seen mortgage rates be absolutely crazy and lots of turbulence in the mortgage markets. This includes many new loan options for banks that are designed to keep people buying, whether it’s new homes or investment properties, etc. However, many of these new loan options are available so you can have significant consequences if you’re not making the decision carefully understanding all the details that said one of the biggest and most important decisions today that you have in today’s loan market should you get a fixed rate mortgage or should you get a variable-rate mortgage?
Most importantly, what even are they? and what are the ramifications of going one way or the other today? We are gonna talk about these details and get you the information you need to make the best decision about fixed rate versus adjustable rate mortgages.
Hello everyone, Nic DeAngelo with Saint investment group. For those that don’t know me, we have over 150 million in real estate assets under management, and we are currently raising an additional 100 million from investors.
Make sure to stay up until the end when I give my recommendation for today’s topic, as well as point you in the direction of a video that can help you learn more.
Let’s jump into it. First things first, let’s talk about the differences. What sets these two types of mortgage structures apart? The simplest way to delineate between the two is that a fixed-rate mortgage has an interest rate that is going to be stable. The entire life of the loan. It will not change, it is fixed.
So for the most common example, let’s say you have a 30-year mortgage at 5% for your first payment, all the way down to your payment at the end of year 30, it is going to be the same rate of 5%. On the other hand, you have an adjustable-rate mortgage, known as ARMs where interest rates can and will likely change over the course of the loan.
Typically these interest rates are tied to different indexes. Historically it was Liborn. Now you’re seeing more commonly Sofer, which is essentially indexes that banks use to track mortgage rates and they commonly tie the interest rate of that loan to that index. So if that index like sulfur goes up, then your rate will go up. If the sulfur index goes down, then typically your rate will go down.
The takeaway here is that in adjustable rate mortgages, the interest rate is gonna fluctuate and therefore your interest payment required is going to fluctuate. Meaning your monthly mortgage will go up and down and you must plan accordingly in that scenario if you get an adjustable-rate mortgage.
So that begs the question. Why do people even get adjustable rate mortgages? Why would anyone ever choose to do something that has the ability to not be locked in and change in the future?
Well, that is a good question and then, and the best answer is many people get ARMs because the interest rate on an arm is typically lower than the interest rate on a fixed-rate mortgage, and because the starting rate is usually lower than the fixed rate at that time in the market, many people are enticed to move towards those adjustable rate mortgages because they have the opportunity to be getting those savings in the present.
Now, the good news about ARMs is that the initial rate typically has a lock period. That rate is set for a period of time, especially in most residential mortgages, known as single-family homes.
Now this rate lock period in ARMs can vary. Sometimes it can be as little as several months, all the way up to a handful of years. But one thing is for certain when you are out of this initial rate lock period, your loan transfers to a variable rate tied to the index that we discussed.
So if your rate is locked for, let’s say five years at the end of five years, your rate will adjust to whatever the calculation is against that index. If that index is higher than your rate lock was, then your payment will be higher. If that index is lower than what your rate lock was, then typically your payment will be lower unless there’s a scenario where they’re adding points to that, like sulfur plus two, whereas a sulfur, a three and your bank has a calculation of plus two. Then you would equal five on that because sulfur plus the bank’s additional charges would equal 5%.
Now, if you’re looking at an adjustable rate mortgage and going, wait for a second, weren’t those the things that had a huge impact on the 2008 financial crisis, or the great recession?
You’re absolutely right. Adjustable rate mortgages had a huge impact and one could argue that helped cause the 2008 financial crisis.
That said banks and consumers and consumer oversight groups have learned a lot since 2008. So there are some good terms that are in effect today. For instance, one term that you’re seeing more commonly today is what’s called a rate ceiling or a rate cap, or it’s how high the maximum interest rate can be for your loan and that’s really good for consumers because, in inflationary environments and things where rates are fluctuating wildly and have a lot of volatility, you don’t want to go into a rate situation, expecting a 5 and waking up with a 15. That can be really scary.
If that’s on a nationwide basis, you might see a massive wave of foreclosures. So it’s in everybody’s best interest to have that rate ceiling for the consumer market. Now on the flip side of that, what you’re seeing commonly is also a rate floor or the lowest level that you’ll see your interest rate reach per your loan agreement.
So that is not to the benefit of the consumer, right? Because if it was up to the consumer, the best thing would be to have a zero rate. That means your cost of getting the money is zero. That would be fantastic, but it’s unrealistic and banks wouldn’t make any money. So why would they do those loans? Right?
So they have a minimum they’re saying, Hey, at the end of the day, we have to make a certain amount. There’s gonna be a floor, the lowest interest rate possible, and a ceiling, the highest interest rate possible.
Overall, in my opinion, I think this is good for both sides. I think it just limits the exposure of both the borrower and the lender and overall just creates more stability in the mortgage markets.
Now we know that adjustable rate mortgages adjust, and now we know that there are ceilings and floors and many deals to look into as well as interest rate locks for a period of time. But what other terms do you need to look out for when you’re evaluating adjustable rate mortgages?
Also, how high can your interest rate and monthly payments jump up at what intervals with each adjustment?
So while there might be a rate the ceiling of how high it can go, is there also a cap or a specified interval of how much your rate can jump at a time? Is it a quarter-point increase at a time or a full-point increase at a time, or is it completely adjusted to an index, to the exact decimal point? Those are good questions to understand. So you know how they calculate your rate at the end of the day.
Also, you wanna know how frequently they recalculate your interest rate. Is it on a monthly, quarterly, yearly basis, etc? You want to know when they rep peg your rate to the newly adjusted interest rate, is there a cap or limit to how low your interest rate can go? If so, what is it? That will help you understand your range of possibilities during this scenario so that you can run the numbers on what your max and minimum mortgage will be, according to your agreement with your bank.
Most importantly, you want to know what you can afford as a borrower. The number one thing you want to avoid in an adjustable-rate mortgage loan is reaching a point where you can no longer afford the mortgage.
In an investment property, this looks like the rents and net operating income. Don’t cover your mortgage payment adequately when you account for your net numbers, after all of your expenses.
For a residential situation where you’re living in your house, you have to look at your income and your expenses as a family or an individual to make sure that at the end of the day, you can pay that adjustable rate mortgage if it adjusts up.
So what about fixed-rate mortgages?
A fixed-rate mortgage is exactly what it sounds like. The interest rate that is due over the course of the loan is fixed for the entirety of that mortgage. The total payment will remain the same every month.
However, you will see a change in the percentage of your payment will go more towards interest and less towards the principal.
Over the course of that loan, however, you will see that shift towards the end of your loan. You’re gonna see more of the money go towards the principle and less of it goes towards interest.
Most importantly, with your payment staying the same from month to month, it is much easier for you to budget. The obvious advantage of this is going to be when there are market fluctuations in the mortgage markets. If mortgages are going high and low and high and low, or there’s any type of major uncertainty, you as the borrower can sleep soundly at night, knowing that your payment is gonna be the same month after month after month.
Early on, they’re typically more expensive than adjustable-rate mortgages. However, this is for a good reason. If you want to think about it, the bank is charging you more for that fixed-rate mortgage out the gate, because they are giving you certainty. You have the certainty that payment is the same for the long term.
So if the mortgage market fluctuates and their cost of capital as a bank or the returns that they need to fluctuate as well with that market, they’re still getting the same money from you every month.
In the case of adjustable rate mortgages, you often will have a lower rate out of the gate because you’re giving up that certainty in exchange for that lower rate. So banks can adjust that rate with their returns. So you’re giving them more certainty with the trade-off of you getting a discount in many cases.
If you wanna think of certainty as a negotiating tool in this instance, then think of it, like whoever holds that certainty is going to trade something for that. If you, as the borrower are willing to give the bank, the certainty of their return is tied to the mortgage index, then by giving them the certainty, you are getting a cheaper rate out of the gate.
So what are the similarities between the two, a fixed-rate mortgage and an adjustable-rate mortgage?
Believe it or not, there are several key similarities between them. The first is the approval process for the loans. Both loans are likely gonna take a very big look at your credit and the property value.
For any loan the lender is gonna look at more than just your income, they will look at your income. If you qualify well for your income, they’re gonna look at the next things like credit. They’re gonna look at the property sales price versus the market or get an appraisal to make sure you’re purchasing the property at a price. That makes sense for them as the lender, as well as checking your credit score as a borrower.
To the lender, your credit score is literally just a score saying how well you pay off your debts.
For this reason, if you have a crappy score, all it says to the lender is that you’re not paying your debts consistently, and they can’t rely on you. For this reason, they penalize you for having a worse credit score. That’s why having a credit score and just paying your bills on time can save you so insanely much over the course of your lifetime. Let me give you an example.
In the process of qualifying for a loan and then checking your credit. Typically there’s gonna be a tier of credit. Let’s say a top-tier credit, like an 800, that individuals are gonna have much better credit than somebody with poor credit would have, like a 568 credit score.
Even though these individuals may be trying to buy the same property at 123 main street, the rate will be much lower for the good credit score and much higher for the bad credit score, because just like the bank and borrower trading certainty on the deal, whoever gets that certainty, trades something for that. If you have bad credit, you’re giving the bank less certainty, so they need to charge more. So the return is higher on that riskier investment, giving you that loan.
The simple reality is someone who has a very bad credit score and someone who has a very good credit score have very different likelihoods of paying that loan back and the bank quantifies that by charging one individual more.
Another loan term, you’re gonna see that’s similar in both fixed rate and adjustable mortgages, especially for the residential side is going to be the term, the length of the loan. The most common lengths of the loan that you’re gonna see are 15 years and 30 years.
For residential purposes, these have just kind of become the gold standard of loan lengths. So it’s extremely common and both fixed rates and adjustable rate mortgages come in both varieties.
The number one question is which loan is best for you.
To help you work through the differences between the two. Here are several questions to ask yourself.
- What is the max mortgage payment you can afford? and what does that equate to as a rate or, what’s the highest rate for your mortgage that you can afford? If you were looking at your rate adjusting?
- How long could you live at the property?
- Can you trust your income for a long enough period of time to sustain your living in the property for the amount of time that you’re expecting to?
- And possibly the biggest question that also has the least amount of answers is anticipating interest rates going?
- What have the trends shown for interest rates and what are the trends showing into the future?
The reality of this question is it’s way bigger than any one of us. You have the Federal Reserve, you have the US government, and you have things like inflation.
All of these are so huge that are impacted by not only the United States economy, but the world economy that it’s impossible to know for sure. But you still gotta ask yourself the question and see what the factors are in your expectation of that.
So far, there’s been a lot of discussions about why adjustable rate mortgages have a lot of drawbacks.
For that reason. Let’s take a minute to see who might be a great fit for adjustable rate mortgages depending on their situation.
The first is the short-term homeowner. For this individual, an adjustable rate might be an excellent choice. If the payments are overall lower than a fixed rate option, or if you don’t plan to live in the property for long enough for the rates to rise out of that initial lock period.
As mentioned earlier, the fixed rate period of each arm varies greatly, but it’s common to see a rate lock for several years at a time.
So if you plan to keep the property for less than that rate lock period, then an ARM might save you money as opposed to a fixed rate mortgage, because it’s typically lower out of the gates than a fixed rate. Let’s use a real-life example to get an idea.
Let’s say the interest rate environment means you can take out a five-year arm with an interest rate of 4.5%, a fixed rate 30-year mortgage by comparison might give you an interest rate of say 5.25%. If you plan to move before the five-year arm resets to adjustable rates, then you will likely save a ton of money on your mortgage interest in that time.
On the other hand, what this also does is limit your options because if you decide to stay in the house for longer than that five-year period, and you change your plans and change your expectations, then what could happen is you subject to market rates then what could happen is you’re subject to the market rates of that time, which might be much higher. But if you’re 100% positive, you will stay in the home for less than the rate lock period. An arm might be a good option for you.
Another great example of someone where a fixed rate mortgage, where an adjustable-rate mortgage could be a really good option for is the bump up in earnings individual. So what does that mean?
That’s the person that expects huge increases in their income over a relatively short period of time. One example might be an early professional like a doctor or a lawyer just getting started. Their income at that exact moment might be a little bit lower, but their expectation to increase their income is likely much higher. Even in the short term. If that’s the case, it might benefit that individual to get the lower rate out of the gates by getting the arm.
But even if those payments increase in the future, they’re still covered by their increased income at that time and can likely refinance their mortgage at that time because of their strong income and get out of that loan. If they’re in the third individual that an adjustable-rate mortgage might be. A really good fit is the pay-it-all-off, individual. This is the person that wants to pay their mortgage off as quickly as possible.
Taking out an adjustable-rate mortgage for these individuals is very attractive, especially for savvy individuals that save really well, and will likely have the bulk of the money to pay off or to pay significantly down the mortgage balance before the rate lock period expires.
So while this might not include the majority of Americans for those that are going this route, an adjustable-rate mortgage is a great option.
So let’s do a quick recap. First off, a fixed-rate mortgage charges a set rate of interest throughout the life of the loan. Your payment will be the same from the first month, all the way to the last month of your mortgage payment. Even if it’s a 30-year loan.
However, for an adjustable-rate mortgage, there will be an initial rate lock for a period where that rate stays the same and then after that period, the rate will adjust typically in line with the specified index like sulfur. With the adjustable rate structure, the initial locking rate period will be lower than the fixed-rate mortgage, but there’s more risk on the backside once you’re out of that rate lock period, so it adjusts to a higher rate than the fixed-rate mortgage option.
Overall adjustable rate mortgages are gonna be much more complicated than fixed-rate mortgages. But if you’re one of the individuals we mentioned or several other individuals that might be really creative with their financing strategy with an adjustable rate the mortgage could be a great option for you.
In the end, regardless of the loan type that you select, choosing carefully is the best way to avoid costly mistakes. One thing is absolutely sure, and that is don’t choose the adjustable rate mortgage option just because it’s cheaper out of the gate and definitely doesn’t use it just because it’s the only loan option that you qualify to buy the house of your dreams while you might get a cheaper rate out of the gates. The reality is if it ramps up and you can’t afford it, you will lose your property and that includes all of the equity that you’ve built in that property over time.
Instead, it’s likely a better option to find a property or house that fits your budget and you know that even if the rate ramps up, you can afford it.
All that to be said, even with mortgage rates all over the place and there is a ton of volatility in the market, one of the most important things is to continue investing in stable opportunities. For that reason, if you’re looking at things that fluctuate like adjustable rate mortgages, I would recommend that you highly consider and invest in something more stable that will give you more stable returns. Check out the video on our youtube channel titled: income funds, which are one of the most stable investment options for you. Especially if you’re looking at variable rate options or you’re dealing with a lot of market uncertainty.
Check out the income fund video to learn more.
Table of Contents
Frequently Asked Questions:
A fixed-rate mortgage is a form of house loan in which the interest rate remains constant over the whole loan period, often 15 or 30 years. This makes it easy to budget and prepare for the future, as the monthly payment remains unchanged.
An adjustable-rate mortgage (ARM) is a form of house loan in which the interest rate can fluctuate over time, often annually. The rate is determined by an index, such as the prime rate, plus a margin established by the lender. This implies that the monthly payment may increase or decrease, making the mortgage less predictable than a fixed-rate mortgage.
Mortgages with a fixed interest rate provide stability and predictability, as the monthly payment remains consistent throughout the life of the loan. This facilitates budgeting and future planning. Moreover, fixed-rate mortgages often have lower initial interest rates, making them more affordable in the near term.
Initially, adjustable-rate mortgages might provide lower monthly payments than fixed-rate mortgages due to the lower interest rate. In addition, if interest rates fall, the borrower’s monthly payment might reduce, saving them money in the long run.
President of Saint Investment Group
Nic is a two decade seasoned expert in investing and capital raising, specializing in Real Estate and debt markets. With Saint Investment Group, he leads large-scale distressed asset purchases and innovative syndications for investors.