How to Choose Between Fixed vs. Adjustable Rate Mortgages
Adam Luehrs is a writer during the day and a voracious reader at night. He focuses mostly on finance writing and has a passion for real estate, credit card deals, and investing.
Are you wrestling with the question of adjustable rate mortgages (ARM) vs. fixed mortgages? Most of us are at least vaguely familiar with the different types of mortgages available. However, it’s important to know what there is to lose or gain with adjustable rate mortgage versus fixed before you are across the table from a lender. The decision you make could impact your personal finances and profit margin for a long time to come.
For future landlords, there are many variables to consider throughout the life of a loan. Let’s dive into the basics of choosing an adjustable rate mortgage vs. fixed rate mortgage.
The differences between fixed and adjustable-rate mortgages (ARMs)
Fixed-rate mortgages typically come in 15-year and 30-year options. We’ll be discussing the 30-year option as the default unless another loan term is specified. Adjustable-rate mortgages are available as fully amortizing or interest-only loans. We’ll be discussing fully amortizing loans unless otherwise specified.
What is a fixed-rate mortgage?
A fixed-rate mortgage is a mortgage that has a fixed interest rate for the full life of your loan. Your lender can’t make adjustments to the terms of your loan as long as you’re consistently making all payments on time.
Predictability is the big benefit here. You have assurance that your principal payment and interest will not suddenly change. However, having a fixed-rate mortgage can’t insulate you from fluctuations in property taxes or home insurance. You could see your monthly mortgage bill increase if you pay your property taxes to your bank as part of an escrow arrangement. Of course, this is true regardless of the financing option you choose.
A fixed-rate mortgage does protect you a bit from what’s happening in the economy though because your cost (outside of property taxes and insurance as previously mentioned) is unchanged by market fluctuations. Long-term budgeting is easier because you can project your monthly housing expenses for up to 30 years. It’s also simply easier to understand than a mortgage with fluctuating rates.
What happens if you see interest rates plummeting after locking into a fixed mortgage? Buyer’s remorse may kick in if you notice that interest rates have declined since you closed on your mortgage. You’re not without options though! It’s possible to refinance your rental property if you crunch the numbers to determine that you’ll come out ahead after closing costs.
The simplicity of a fixed-rate mortgage doesn’t make it the best option by default. It’s possible that you’ll pay more over the life of your mortgage with a fixed rate. That unavoidable risk is the price of simplicity. Fixed-rate mortgages almost universally come with higher rates than adjustable-rate mortgages.
There is also that chance that interest rates could fall after you lock in your rate. Unfortunately, you aren’t able to take advantage of lower rates unless you refinance. The refinancing process requires new closing costs—and new closing costs can sometimes erase the financial benefits of refinancing to a lower rate.
It can also be a tedious process and don’t forget that your credit can take a hit when you apply to refinance. This could be a pain point if you’ll need to wait for your credit score to bounce back from a refinancing hit before you apply for financing for a new rental property. In addition, you’ll find that fixed-rate mortgage products are more or less identical among all lenders. You won’t be given any room to customize the structure or terms of a traditional mortgage.
Is a 15-year mortgage ever a good idea for a landlord?
Let’s get the big question out of the way. Yes, you’ll probably save money by going with a 15-year mortgage over a 30-year mortgage. This is due to the lower interest rates offered by 15-year products.
One misconception is that 15-year mortgages are less expensive because you can pay them off sooner. This technically isn’t true because you can also pay off your 30-year mortgage sooner if you prefer. The cost perk comes down to that lower interest rate.
Just how much lower? It varies by bank.
However, you can often expect a reduction of 0.5 percent. Keep in mind that a lower interest rate means that more of every payment you make goes right toward tackling that principal. It’s hard to ignore the potential for savings if your aim is to free up more capital for investing in additional properties. However, the 15-year option may actually put you in a worse position for buying more properties.
Yes, you’ll undoubtedly pay less interest on your 15-year loan. However, those monthly payments on a shorter loan can be brutal. The money you’re freeing up every month with a 30-year loan is going to put you in a better short-term position to invest in homes. You can also use the monthly savings to pay down principal or build up a good emergency fund for your business. The flexibility that goes along with a 30-year mortgage is generally going to be more appealing for landlords. Let’s move on to adjustable-rate mortgages.
What is an ARM loan?
As the name implies, an adjustable-rate mortgage is a loan with an interest rate that fluctuates. Rate changes aren’t unannounced or sporadic. You’ll be agreeing to some very specific terms regarding when and how your rate can change. An adjustable-rate mortgage (ARM) is far more complicated than a fixed-rate mortgage. Complicated isn’t always bad though. An ARM offers the potential to save money over the life of a loan. Let’s go over what to expect as you shop around for ARMs from various lenders.
An adjustable-rate mortgage typically starts off with a very low initial interest rate. This makes ARMs look very attractive when doing rate comparisons against available fixed-rate mortgages. Of course, that low rate isn’t set in stone. The rate rises and falls based on the index that it is connected to. It’s important to put on glasses for looking at both the long view and short view when considering an ARM.
What period of time does an ARM cover? The 5/1 ARM is the most popular adjustable-rate option. The terms of the 5/1 ARM lock in your signing rate for five years. Your interest rate can change once per year after that. It’s also possible to find 3/1, 7/1 and 10/1 ARMs from lenders. All of them follow the same general terms as the 5/1 ARM. We’ll break down how the different ARMs work in more depth in just a minute.
The big benefit of an ARM is that you’re going to save money at the ground floor. In fact, the lower cost of entry often entices many first-time buyers who might struggle with coming up with the monthly payments based on a 30-year loan term. ARMs are typically attractive to residential buyers and investors who need to skim some costs from the full cost of entry. Honestly, many landlords don’t choose ARMs. That doesn’t mean that it’s never appropriate for a landlord to purchase a home with an ARM.
The monthly savings you’ll get during the first five years of owning a rental via an ARM can help with profitability. This is meaningful if your plan is to build a portfolio as quickly as possible with as little investment as possible. ARMS are typically used by people who are interested in qualifying for homes that might be out of their price ranges using fixed-rate loans. Is that a sound approach? It really comes down to your own judgment call.
The main negative of an ARM loan is that it can be a little bit more complex, and of course, there is a possibility for much larger payments over time. There is always an element of the unknown. It is always a bit more difficult to plan your finances ahead of time with an ARM.
In addition, people tend to place a lot of emphasis on the fact that ARMs can increase. However, on the positive side, it’s likely that you’ll also see your rate dip during certain periods anyway. That means you get to sit back and enjoy the perks of refinancing to the latest rate without doing a lick of work. Yes, it’s probably reasonable to say that you’re “taking a gamble” when going with an ARM. Doing this properly relies on the fact that you’re never biting off more than you can chew even if a worst-case scenario enters the picture.
Adjustable-rate mortgages are also often used by people who aren’t planning to stay in a home for very long. In addition, people in “hot markets” will often use ARMs when sitting on a property they intend to sell for profit.
What does that mean for you if your intention is to be a landlord? An ARM can be a bit of a mixed bag for a landlord. Most landlords purchase properties with the intention of paying them off fully. This is common among landlords looking to create steady income for the post-retirement years. Obviously, a rental property that is fully paid off ultimately generates higher monthly profits. You may not be worried about taking the long, slow road of the fixed-rate mortgage if you’re a long way away from retirement.
Comparing fixed-rate and adjustable mortgages in real terms
It’s really impossible to do an apples-to-apples comparison between a fixed-rate and adjustable-rate mortgage unless you have a crystal ball. That’s because you can’t compare a static percentage rate to a floating percentage rate for a long-term projection. However, we can still get a good baseline comparison for what your loan might look like using an imaginary home purchase.
We’ll say that you find a great rental property that requires a $200,000 mortgage after the down payment. We’ll use an imaginary 5/1 ARM against an imaginary fixed-rate mortgage for this example to show you what costs could look like during your five-year intro period. Here’s a look:
30-year fixed-rate mortgage
● Mortgage amount: $200,000
● Interest rate: 4.3%
● Monthly payment: $990
● Mortgage amount: $200,000
● Interest rate: 3.3%
● Monthly payment: $876
Let’s investigate how that five-year (60 months) period looks for each option. You’ll pay a total of $59,400 for your fixed-rate mortgage during those five years. Your 5/1 ARM will cost you $52,560. That means you’ll save $6,840 over five years.
That cost difference can be particularly enticing for landlords and property investors. After all, that nearly $7,000 in savings could represent a down payment for a new rental property. Of course, there is the fear that your interest rate could spike after the five-year introductory period.
A closer look at the different types of ARM loans
We already covered that the most common type of adjustable-rate mortgage is the 5/1 ARM. You may have several options for a fixed rate period presented to you if you meet with a lender. Let’s make sure you know what’s involved! Here’s a glance:
● The 10/1 ARM is fixed for 120 months. Your rate adjusts annually for the remaining loan term.
● The 7/1 ARM is fixed for 84 months. Your rate adjusts annually for the remaining loan term.
● The 5/1 ARM is fixed for 60 months. Your rate adjusts annually for the remaining loan term.
● The 3/1 ARM is fixed for 36 months. Your rate adjusts annually for the remaining loan term.
Your first number is how many years your rate will be fixed. The second number shows how many times per year your rate can increase. You will have some warning before a rate switch. Your rate adjustment takes place on the anniversary of your mortgage each year. It’s also important to know some terms associated with ARM loans that will influence the terms of your loan.
This is the economic indicator used to calculate your ARM’s interest rate.
This is the number dictating how much your interest rate can change once your fixed period is over.
This is the limit your rate can be raised over the full lifetime of your loan.
This is the maximum your interest rate can increase between adjustment periods.
As you can see, ARMs may not be as “wild” as they appear at first glance. Your loan will have caps in place that prevent total unpredictability. Of course, the caps attached to your specific loan could determine whether or not you’re making a safe bet.
A note on interest-only ARMs
We mentioned briefly that ARMs comes as fully amortizing or interest-only loans. Most ARM products are fully amortizing. An interest-only ARM is a product that only requires you to cover monthly interest payments. What’s the catch?
You’re making very low payments because you’re not covering any principal. However, those chickens will come home to roost at the end of your mortgage term in the form of a balloon payment. A saving grace of an interest-only ARM is that it does typically have a maximum interest rate that cannot exceed 12 percent. This can be a good option depending on how you play things. Yes, extremely low payments do give you an opportunity to save or invest money. You may be able to cover your balloon payment easily because you’ve been able to grow the money that would have otherwise been sucked up by principal payments. However, this is not an option that should be used without some very strategic planning.
Which option makes sense for landlords?
Which mortgage option fits into your investment strategy? Truthfully, ARMs aren’t always best for landlords. However, there could be scenarios where they’re advantageous. Here’s a look at when to consider an ARM:
● A fixed-rate mortgage won’t provide enough cash flow.
● You want to juggle multiple mortgages.
● You’ll sell the property before your fixed-rate period ends.
Don’t just focus on the “fair weather” aspects of an adjustable-rate mortgage. Sit down to run the numbers of a worst-case scenario based on the specific caps of the loan product you’re considering. Will you still be able to afford a mortgage if and when the “maximum” caps are in play?
One “trick” for insulating yourself against spikes in interest rates is to make extra principal payments during the early part of your loan. This will reduce the size of your loan. As a result, any higher rate that you’ll pay in the future will be based on a smaller loan amount.
Keep an eye on rate trends
No, you can’t be expected to predict every twist and turn in the market that will impact your mortgage’s interest rate. However, having a general understanding of interest-rate trends is part of being an informed consumer. Keep an eye on what interest rates are doing before you commit to a loan type. Does it look like interest rates are going to fall? Your ARM will allow you to cash in on a drop. However, a drop in interest rates won’t do you any good if you’re paying a fixed rate. Conversely, climbing interest rates could signal that the climate is wrong for an ARM. You’ll be thankful for the shelter of a fixed-rate mortgage if rates rise steadily.
What can you live with?
This is the question you ultimately have to ask yourself before deciding which type of mortgage is appropriate for you. Do you want to be protected when interest rates rise? Is it more important to enjoy five years of low payments while you build other investments?
Typically, the answer for landlords is the 30-year fixed-rate mortgage. This option provides the predictability and flexibility that many landlords want. Yes, you’re sacrificing some options for playing around with your capital when you choose a fixed-rate mortgage. However, you’re avoiding the need to be highly strategic about how to manage your property portfolio. We’ll just say that the fixed-rate approach leaves less room for plans to backfire.
What happens if you choose the ARM? It’s important to factor in both where you stand today and where you’ll stand when loan terms change. Do you anticipate that you’ll have a higher income from rentals by the time your rate adjusts? It could make sense to risk higher payments later if those payments will have less of an impact. Of course, this feels like too much of a gamble for some. You may simply feel more comfortable locking in one rate based on what you can pay per month as things stand today. An ARM probably isn’t for you if that’s the case.
The adjustable-rate mortgage is often spoken about like the loose cannon of the mortgage world. Yes, it’s entirely true that some people have gotten into trouble due to unexpected rate spikes or balloon payments they really didn’t understand. In fact, many of the problems that arise from ARMs stem from a borrower’s lack of understanding. An ARM is not something you want to take lightly. In fact, this might not be an ocean you want to tread in without the assistance of a financial adviser.
Landlords do have some advantages over straight investors when it comes to the interest totals that you’ll rack up using either a fixed or adjustable rate. As a landlord, you can deduct the interest that you pay on the mortgage of your rental property. This is not the case if you’re taking out a mortgage for an investment property. It’s important to keep that in mind as you play around with your numbers.
The final word
About to get in the market for a mortgage? You can’t shop for a financing option until you know your long-term plan. A landlord often has different objectives than people who are looking to fix and flip. There’s a good chance that a fixed-rate mortgage is going to fold nicely into your plan for owning a property for a long time while taking advantage of deprecation and other profit-building deductions. It never hurts to run the numbers on principal and interest for several types of loans before you commit.
Disclaimer: The above is provided for informational purposes only and should not be considered tax, savings, financial, or legal advice. All information shown here is for illustrative purpose only and the author is not making a recommendation of any particular product over another. All views and opinions expressed in this post belong to the author. NMLS ID: 1125207 Terms, Privacy, and Disclosures. Copyright LendingHome Corporation 2020.