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The 30 Year Fixed: Insurance You Probably Don’t Need

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Bonus: Anti 30 Year Fixed Propaganda

 

Quick bonus coverage from my post earlier today: I mentioned that I wanted you to remember Part B from that material. 

In case you forgot (tsk tsk) here it is again: B) the VAST majority of mortgages are held for less than 10 years

You’re average Loan Officer isn’t going to go into much detail on this fact.  It’s not because they don’t know it (although they might not), or because they are a bad person (although I make no promises there either), but simply because it’s risky to talk about ARM’s, or adjustable rate mortgages, these days since many people attribute the crisis of 2008 to them.  In short, ARM’s weren’t the culprit…terrible lending practices, greed, ignorance, and an absence of common sense in underwriting did—among other things.

Responsible uses of adjustable rates were the proverbial baby in the bathwater.

While your Loan Officer may not find it prudent to educate you on what responsible ARM use looks like, I've got nothing to lose, so here you go.

Look, we have a lot of clients that choose to buy homes in one location knowing full well they won’t be there permanently.  Even when they “PCS”, they know of course that it’s not “P”, if you will. 

So why on earth would you pay a substantially higher rate for a 30 year guarantee?

Not everyone understands ARM’s, so in short:  they are amortized over 30 years, just like a 30 Year Fixed, and they have a “fixed period”, again just like a 30 Year Fixed loan does.  The difference is that after the fixed period on an ARM, your loan rate can adjust up or down.  The 30 Year Fixed loan has a fixed period that doesn’t end, until it’s paid off of course.  A 5/1 ARM has a fixed period of 5 years then adjusts every 1 year; a 7/1 ARM has a fixed period of 7 years and adjusts every 1 year; and so on.

A 10/1 ARM has a fixed period that according to multiple sources will outlast most of the mortgages anyone will take out during their lifespan, between moving, refinancing, cashing out, etc.

Example: If you thought you were going to own your home for another 4 years, and I told you that the average American lived in their home for 9 years before selling it (according to the NAR) then a 5/1 might be too risky, and a 7/1 would probably cover you, but a 10/1 would almost ensure you never had to face readjustment.  Knowing this, if I offered to charge you a half a percent of your loan every year as an insurance policy against your rate going up 5%--for years 11-30--you would probably tell me to take a hike.

 

As one Vice President of  Commercial Services for a regional bank put it, when discussing his personal loan: 

My evaluation is essentially am I willing to pay $30,000 over 10 years for the insurance that over the next 20 years my interest won’t be more than that (adjusting for TVM)...

...that’s the key that I don’t think people realize they are doing. Everyone is content to just sit on their current rate because it’s easy to do nothing. But by doing nothing you are essentially saying you’re ok with paying X dollars more and in some cases you’re really not getting anything for it.  

Yet, that's essentially what most people actually do in that situation by taking out a 30 year fixed loan.  Right now, the 10/1 ARM is 0.5% lower than the 30 Year Fixed (30YF).

 

Heck, using rough math, even if your loan skyrocketed 5% (which in most cases is the absolute most it can EVER go up) but you saved 0.5% every year for 10 years before that, then the worst case scenario is just breakeven in year 11, so it really buys you 11, not 10, years of security (10 x 0.5% equals a 5% savings over 10 years, then it’s hypothetically given back in year 11 in this scenario).  Really, it's actually more dramatic of a savings than this because your lower rate is applied to a higher balance and after 10 years of paying it down, the rate increases on a lower balance (if it increases at all, but since we are near all-time lows, let's just assume it will).

So, again, most of you should be demanding an ARM, but few of you are.

To recap this rather in-depth review:  Rates are near all time lows, not at them.  However, that doesn't mean you should sit and wait for them to go lower...they are low enough for most Veterans to find value.  Also, unless you think you're really going to need it, don't waste money on a 30YF loan.  If you plan on keeping your house forever, and even renting it out down the road, maybe the advice is different, but maybe not once you factor in the time-value of money.

The 10/1 ARM, in particular, is a good tool in another scenario (as a 15Y or 10Y fixed could be as well.  To borrow another banker's analysis:

I think [the 10/1 ARM] is especially great for people who are getting close to retirement as it gives them a great opportunity to save money when they probably only have 10-15 years left on their mortgage anyway.  I think people like that have the concern: “Yeah, but I’m close to paying it off and I don’t want to have it out there for another 30 years”.  Easy solution, do the refi into the 10 year arm, but set up your payments so you automatically make extra principal payments each month so that you are making the same payment as before.  The result is that the interest savings will allow you to pay the loan off even faster.  Or like you mentioned Mike, you can take the interest savings and invest it (and still be able to apply extra principal payments to keep the amort the same).

In any case, I hope you learned something today.  Don't let abstract fear make your financial decisions for you.  Do the math, ask an expert, and evaluate for yourself, with your own personal goals in mind.

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  1. […] Remember Part B above…it’s important.  I’ll come back to it later. […]

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