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Fixed or flexible: Doing the mortgage math

Fixed-rate mortgages offer borrowers stability and consistency.  Adjustable-rate mortgages offer buyers upfront affordability.  Which is better?  It depends on more than just interest rate levels. -- By Gayle B. Ronan
New Home Construction Continues To Rise
A sold sign sits near a home site in the Magnolia Creek subdivision in League City, Texas last year. Rising short-term interest rates have narrowed the gap between adjustable-rate mortgages and fixed rate loans.Dave Einsel / Getty Images file
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After 15 rate hikes by the Federal Reserve, many economists are predicting the Fed is nearing the end of its tightening cycle. So, should prospective and current homeowners lock into the stability of a fixed-rate mortgage or remain flexible and favor adjustable-rate products?

“Yes. No. Maybe,” answers Joe Rogers, an executive vice president with Wells Fargo Mortgage in Columbia, Maryland. 

He is not being evasive. Given the number of mortgage products now available, the "right" answer depends on a borrower’s current budget, financial objectives and housing plans, more than the Fed’s moves.

Though rising interest rates have weakened demand for adjustable-rate mortgages (ARMs), it is not by as much as one might think. “[ARMs] share of all mortgage applications have declined from 35 percent to 27 percent,” says Douglas Duncan, chief economist for the Mortgage Bankers Association in Washington. Obviously, he adds, “a significant number of households still find ARMs useful.”

For instance, ARMs may be beneficial to borrowers planning to sell their homes within a few years by minimizing monthly payments through slightly lower rates than available on fixed-rate loans. For those whose loans are big enough, the refinancing costs may be more than offset by rolling annually from one low “teaser” ARM product to the next. But wider acceptance of interest-only loans is also a factor, according to Duncan.

Though interest-only loans often have fixed rates and behave similarly to a 30-year loan, they are classified as ARMs, because monthly principal payments are optional. They are becoming more popular because, says Duncan, payments effectively behave like tax-deductible rent allowing borrowers to direct would-be principal reduction amounts to other expenses or savings goals. Yet, unlike a rental, as the value of the mortgaged property increases, the borrower builds equity in the home. This is why interest-only products have been favored by higher net-worth types who already have significant home equity and, more recently, by those stretching to buy a home.

Keeping payments as low as possible for cash flow purposes and hoping home values continue their historical climb are the rationales behind all adjustable products, not just the interest-only loans, explains Duncan. From an investment prospective, using such leveraging maximizes the homeowners’ total return — assuming they bought well and home values rise — while freeing up monthly cash flow for other purposes.

But mimicking the leveraging strategies of sophisticated real estate investors introduces greater risk into borrowing. The risk that monthly payments will fluctuate upward with interest rates to a point where they become burdensome. That could soon be the case for those who took out ARM products in recent years and for those who took out home equity loans.

Such borrowing for maximum leverage or flexibility requires continually monitoring rates, predicting of where rates are headed and making comparisons among the growing number of mortgage products available to ensure the most advantageous one is being used for current conditions. It means actively managing debt the way one does assets, like a stock portfolio.

What does that involve? First, understanding what causes interest rates to move and anticipating when they will. While the Federal Reserve sets short-term interest rates — impacting the indexes underlying adjustable-rate products — it does not control long-term rates. Those rates are primarily determined in the bond market. This is why, despite the Fed’s increases, rates on 30-year fixed mortgages barely nudged up allowing borrowers to shift into a fixed rate product at nearly the same rate currently available on an ARM.

Another thing to understand, says Pete Bonnikson, senior vice president in the First Mortgage Unit for E-Loan in San Francisco, “is that even when the Fed finishes, it takes time to come off an interest rate peak. Rates on adjustable loans will not come down anytime soon, nor will anyone’s ARM payments.” 

That will be especially true for borrowers in pay-option products, he adds. Their rates usually move with a lagging index. These borrowers will face rising payments months after the Fed stops raising rates.

Similarly, people with fixed-rate first mortgages and floating-rate second mortgages — which are adjusting upward with each rate increase — need to do some math. “Rolling all their mortgage debt into one new fixed rate loan could produce a savings,” says Rogers.

When reviewing mortgage arrangements, Rogers stresses there are three key questions borrowers should ask before applying for any loan: How long will the rate stay level? What index is the rate tied to? What is the margin or amount being added to that index if it is adjusting?

“It’s important to take the time to understand which parts move, when they move and by how much,” agrees Duncan. “Too many homeowners focus on the current monthly payments and are getting themselves unintentionally involved with sophisticated loan products.” Some, like the pay-option products, can actually lead to negative amortization in exchange for low and level monthly payments. This situation arises when the difference between what a borrower should be paying and what the borrower is paying in interest is added to the loan’s outstanding balance, causing the loan balance to mushroom. 

“From 2001 to 2005 it was an easy call on what product to use,’ says Rogers. “Today, price alone no longer works. With all the new products and concepts, people need to work out different strategies or have a consultant work them out and explain them before making any decisions,” he adds. 

Online tools like those offered by , , or available at allow borrowers to do just that — explore what-if scenarios with their current or planned loans and identify advantageous financing options before ever speaking with a mortgage consultant about the pluses and minuses of each.

Duncan, who expects a flat interest-rate yield curve to persist (where short- and long-term rates are relatively close together) adds, “With a flat yield curve, choosing the right mortgage is more complicated. There are fewer good reasons for using ARMs — but it is well worth a borrower’s time to do the math to see if they would be better off in one.”