Anyone buying a home should know about this term. But even after getting a total of 5 Mortgages (3 purchases, 2 Refinance) over the last 6 years I learn something new each time.
Fixed rate is exactly what it sounds like it is fixed for the life of the loan. The 30 year fixed rate tends to be the default option. Many people give unsolicited ad"vice" that you should always lock in a 30 year rate when you think the interest rates are low.
But this is not the right strategy. Why? Read on...
The decision of Fixed vs. Variable rate should be based on how long you think you will live in the place you are buying and your view of where the interest rates are going; or how long you are going to hold onto the property. If you are 100% sure you will not move from here or you have made up your mind you will hold onto this property forever that's when locking in a 30 year fixed rate might make sense. But even then you should weigh it against the Variable rate option and how much lower interest rate you are going get with this option.
Variable rate loans (7/1 ARM which is the most popular) tend to have lower rates of about 0.5% to as much as 1.25% for the initial period of 7 years (the loan payment is still calculated based on a 30 year term) and then will reset higher by upto 1% or 2% higher or lower every year with a (floor of 2% or cap on increases). Most people are nervous about this option because of the possibility of the rates going higher and default to the higher rate 30 year fixed mortgage. The risk of interest rates going higher is something that is over hyped in my experience.
Look at the chart below: Except for brief 10 year period in late 70's and early 80's the 30 year fixed rates have been falling. So, every time you looked at a 30 year fixed rate it would have been a "low" rate compared to history since the early 90's and you would have made a mistake by taking the 30 year fixed rate instead of a variable rate....You would have always been better off taking a variable rate....as you would have paid less interest and more principal in those periods.. and then could have re-financed to a 30/15 year fixed rate or another ARM...as your loan balance would have been much lower...
Also, remember that there are several fall backs when you take an ARM mortgage and you see the interest rates are going materially higher:
1. Refinance without waiting the 7 year term
2. Paying off a portion or all of the Mortgage with a 401K loan (where you pay the interest to yourself and dollar cost average back into the market at a lower point as theoretically as interest rates rise the market will fall -- see my blog on 401K loan ad"vice") , and negotiating a lower interest rate during your re-finance as you may be at a much lower loan to value ( typically banks knock of 0.25% for every 10% lower loan to value)
3. Know that there is a Cap on the rate...and if push comes to shove...you will pay the high rate for a few years before you re-finance...not the entire term.
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