Fixed-Rate Mortgages Making a Comeback

Fixed-rate mortgages are making a comeback: Due to recent developments in the mortgage industry, the collapse of the sub-prime market that caters to high-risk borrowers and the escalation of interest rates on many adjustable-rate mortgages have produced a new trend, the come back of Fixed-rate mortgage.

Fixed rates fashionable

The fixed-rate loan trend was confirmed in a recent report in the Washington Post newspaper: There is a direct correlation between adjustable-rate mortgages and a national surge in loan foreclosures, prompting many homeowners to rediscover the value and inherent benefits of fixed-rate mortgages.

Fixed-rate mortgages are desirable because the interest rate does not change; instead the interest rate is “fixed” and cannot change over the life of the loan, which typically is 30 years, but can run for terms of 15 years to 40 years.

Adjustable-rate mortgages (ARMs) allow the interest rate to fluctuate up or down at specified times to reflect new market conditions. It is not uncommon for ARMs to offer low “teaser” rates that initially are lower than fixed-rate mortgages, but after a year or a few years, the rates gradually move higher and higher so that they are higher than fixed-rate mortgages. Typical ARMs adjust after one, three, five or seven years, but depending on the terms of the loan, an ARM interest rate might change several times. It is not unheard of that an ARM went from 4 percent (an excellent rate) to 6 percent (pretty good) to 8 percent (not good) to 10 percent (terrible) within a few years.

The bottom line on ARMs is: Can be good in the short term; Can be really bad in the long term.

There are pros and cons of each type of financing, which we explored in a previous article, but the disadvantages of ARMs – primarily the uncertainty about how high the interest rate could go — outweigh the disadvantages of fixed-rate mortgages for most borrowers.

The problem for many people who hold ARMs is that they leveraged their financial position to a maximum level and bought the most expensive home they could get with an ARM, a loan that typically allows them to buy a higher-priced house than a fixed-rate mortgage would. They were on a razor’s edge financially from the start, but when the ARM adjusts, they suddenly owe several hundreds more on their home loan EVERY MONTH. That scenario is what tends to produce more foreclosures — because people become stretched too thin and are simply unable to pay.

For example, a family who bought a home five years ago chose an ARM over a fixed-rate mortgage because the ARM was cheaper THEN. They enjoyed a few years of below-fixed-rate payments, but the loan recently adjusted and now the rate is higher than the fixed rate was then or is now. They are now paying $400 more per month toward the mortgage than before, straining the family finances. If they have maintained excellent credit, they could refinance into a new ARM or choose a fixed-rate mortgage.  But if they have had any credit problems or have little savings, they may be unable to refinance at a better rate or obtain a preferred rate on a new loan. So their choices are: Stay in a bad loan that could get worse or opt for a new loan that won’t be as good as a fixed-rate loan would have been in the first place. Plus, the closing costs associated with obtaining any new loan can run several thousand dollars, catapulting them into additional debt in an effort to SAVE money.

(Although a handful of companies have introduced “no-cost” loans,which they say they will cover the closing costs because of deals they have made with the lenders, don’t believe the hype. Think about it: if they are willing to eat the closing costs, they will recover that cost some other way, usually with a higher interest rate.)

All of this uncertainty and the threat of foreclosure is why fixed-rate mortgages have re-emerged as the most consumer-friendly type of loans. 

“Having predictable monthly payments enables homeowners to better plan their budgets, insulate themselves from shock should interest rates rise and ultimately build wealth,” the Washington Post states in its article about the renewed favor of fixed-rate mortgages. ARMs “had a burst of popularity in recent years as housing costs climbed and would-be home buyers stretched for any savings they could find.”

In addition, ”the gap between the rates on fixed and adjustable loans has narrowed dramatically in recent months,” the Post reports — sometimes to a negligible $50 difference — making fixed-rate mortgages more competitive with ARMs, even in the short term.

Fixed-rate mortgages provide peace of mind in the certainty that the interest rate will not change during the life of the loan, while ARMs include the risk of higher payments in ensuing years.

ARMs remain a viable option for many home buyers, especially for people who don’t plan on staying in their new home forever. Fixed-rate mortgages are best for people who want to stay for several years, although opinions differ about those who plan to remain for between five and 10 years. If you’re going to stay less than five years, an ARM may be your best option. If you’re going to stay more than 10 years, a fixed-rate loan is usually the way to go. If you plan on staying between five and 10 years, consider both options. If you can get a 5/1 ARM or 7/1 ARM (loans that don’t reset until five or seven years, respectively) you are basically getting a discounted rate for the initial period and then need to decide what to do as the loan approaches its adjustment time.

In our next post, we’ll discuss some tips offered by the Federal Trade Commission about questions to ask when shopping for a mortgage.
   

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