Since 2009, I have encouraged Financial Samurai readers to take out an adjustable-rate mortgage instead of a 30-year fixed-rate mortgage. The rationale was that we were in a downward interest rate channel, so why pay more in interest if you don’t have to?
Further, the average homeownership tenure back in 2009 was only around 5-7 years. Therefore, it was illogical to take out a more expensive mortgage for a much longer fixed-rate duration. Today, the average homeownership tenure is 10+ years given the desire for real estate has boomed.
Because I practice what I preach, I’ve taken out multiple adjustable-rate mortgages (ARM) over the past 13 years, thereby saving well over $300,000 in mortgage interest expenses. In fact, my existing primary residence mortgage is a 7/1 ARM at 2.125% taken out in 2020. Score!
However, while all this time I had thought I had been making a difference by helping people save money on their mortgage expenses, it turns out, my message had been ignored and fallen on deaf ears!
Adjustable-Rate Mortgages As A Percentage Of Total Mortgages
Take a look this great chart put together by Rick Palacios of JBREC. It shows that adjustable-rate mortgages as a percentage of total loans are only 4.7%! Holy heck! I would have guessed the percentage was closer to 25%.
In other words, the vast majority of mortgage borrowers have 30-year fixed-rate mortgages and to a lesser extent, 15-year fixed-rate mortgages, which I like.
Why Did The Percentage Of Adjustable Loans Shrink So Much?
The percentage of adjustable-rate mortgages to total loans shrank from a high of roughly 34% in 2005 to less than 5% in 2022. The decline began when the housing market peaked around 2006 and bottomed in 2009 at around 2.5%.
Adjustable loans declined in popularity due to:
1) A big slowdown in demand for housing
2) Declining interest rates, resulting in lower 30-year fixed-rate mortgage rates
3) A decline in housing prices, making homes more affordable with fixed-rate mortgages
4) A reduction in mortgage lending and interest rate risk by banks
5) An emphasis by mortgage lenders, pundits, and advisors to take out a 30-year fixed-rate mortgage
6) The desire for predictability and comfort due after suffering real estate losses
Not Trying To Be Contrarian With Mortgages
I haven’t been recommending readers take out an ARM to buy a home to be a contrarian or get attention. My #1 goal has always been to help you save more money and make more money so you can do what you want.
Since 2009, taking out an ARM has been the absolute correct call. If you took out an ARM, you paid at least a 1% lower rate on average than if you took out a 30-year fixed-rate mortgage. On an average $300,000 mortgage, that’s $3,000 a year in gross annual interest savings or $30,000 in savings after 10 years.
Further, before your ARM reset, you most likely could have refinanced your ARM to another ARM for the same or lower rate, at little-to-no cost. Or, you could have let your ARM’s introductory fixed-rate period expire. If so, your new rate would have likely stayed the same or gone down.
I used the $300,000+ in mortgage interest savings since 2009 to invest in stocks and real estate. From those investments, I’ve been able to boost my passive income by ~$30,000.
Below is the 40-year downward trend of the 10-year U.S. Treasury bond yield. Do you really want to bet against a long-term structure trend? Nah.
ARM Or 30-Year Fixed In A Rising Interest Rate Environment?
So what should homeowners or prospective homeowners do now that we’re in a Fed-rate-hike cycle? The most rational answer is to match the duration you plan to own your home or pay off your home with the fixed duration of the mortgage loan.
In other words, if you plan to own your home or pay off your mortgage in 10 years, get a 10/1 ARM. If you plan to take 28 years to pay off your home, perhaps getting a 30-year fixed-rate mortgage is more appropriate.
That said, I still recommend an ARM over a 30-year fixed rate mortgage, even if you plan to own the home or take longer to pay it off.
Here is the main reason to get an adjustable-rate mortgage:
Mortgage rates may go up during your ARM’s fixed-rate duration. But chances are high mortgage rates will head back down before your ARM resets. The most common types of ARMs are 5/1, 7/1, and 10/1 followed by 3/1. The longer the introductory period of your ARM, the greater the chance mortgage rates will head back down for the reset.
Even if mortgage rates are higher during the first year of a reset, you will have paid off some of your principal balance. As a result, a lower principal balance will help offset the higher interest rate. There is also a maximum interest rate hike the first year and maximum interest rate cap.
Further, you saved money during the entire duration of the introductory fixed-rate period, which provides a buffer for higher rates. Finally, in the future, you will mostly likely be making more money.
Mortgage Rate Comparison Example
Let’s say I take out a $1 million 7/1 ARM that is at 3.5% versus a 30-year fixed-rate mortgage at 4.5%. In seven years, I will have saved $70,000 in gross mortgage interest.
If after the seventh year, my ARM resets to 4.5%, I’m paying the same interest rate if I had taken a 30-year fixed-rate mortgage, a decent possibility.
If my ARM rate resets by 2% to 5.5%, I have seven years at 5.5% before getting a 30-year would have started saving me money. A 2% increase is about the most I expect mortgage rates to increase.
However, the chances are greater than 80% that sometime during this 14-year time period before I start losing, I would have sold the property, seen mortgage rates go down again, or paid off the mortgage. In the 20% chance I still have the mortgage, the principal balance would likely be 30% lower.
A 30-Year Fixed Rate Mortgage Is Overrated
If you are a first-time homebuyer, do you really think the first home you buy will be your forever home? Of course not! You will likely make more money, start a family, or relocate for a job and buy a nicer home. Therefore, getting an ARM is better for newer homebuyers.
If you are a veteran homebuyer, do you think taking out a 30-year fixed-rate mortgage will give you more peace of mind? Probably not once you realize you are paying a higher interest rate than you need to. Given you are older, you’re likely wealthier with a lot more financial alternatives. As a result, you can afford to save money on your mortgage.
Let’s say mortgage rates continue to surge to the moon. My 2.125% 7/1 ARM looks like it will reset to 6% in the year 2027. What should I do?
I’ll simply continue to pay my mortgage as usual until 2027 without any extra principal payments, especially given real mortgage rates are negative. Then I’ll set aside reserves over the years to pay down some or all the principal balance before I have to pay 6%. There’s no way you’re going to get me to pay a 3X higher interest rate!
The Percent Of Adjustable Rate Loans Should Go Higher
The percentage of adjustable-rate loans to total loans will likely increase because everybody is rational and wants to save money. With higher home prices and higher mortgage rates, more buyers will be trying to save by taking out ARMs. I suspect the percentage of adjustable loans will rise to 10%+ over the next three years. And if all borrowers read Financial Samurai, I think the percentage would surge to 50%.
If you take out a 30-year fixed-rate mortgage after a big move up in rates, you’re locking in higher rates for a long time. That’s like admitting defeat. Instead, by getting an ARM, you lock in a mortgage rate for a shorter duration, pay a lower interest rate, and then get a chance to refinance at a lower rate in the future.
An adjustable-rate mortgage will likely save you money over a 30-year fixed-rate mortgage. And there’s nothing I like more than saving money while investing in my favorite asset class.
Readers, are you surprised adjustable-rate loans as a percentage of total loans are so low? Why do so many people like taking out 30-year fixed-rate mortgages at higher rates?
If you’re looking to refinance or get an adjustable-rate loan, check out Credible. Credible is a leading mortgage lending platform where a half-dozen qualified lenders compete for your business. Getting a real mortgage quote is free. Mortgage rates have actually started to dip again.