Is a fixed or variable rate mortgage better?

/ Source:

Q: I am 25, single, and a licensed builder planning to build my first home in the next couple of months.  I am getting different opinions as to a fixed rate or a variable rate.  I probably wouldn't stay in the house for more than a couple of years, but you never know what the future holds. A variable rate would mean I would have a smaller payment, but I am also afraid I would be forcing myself to make a move or pay a substantially higher payment in a few years. — Tim G., Grandville, Mich.

A: Well, you can’t have it both ways. When you take out a fixed-rate loan, you and the bank are both making a bet on the future course of interest rates — that’s why a fixed rate loan is higher than an ARM. The bank has to charge more because if rates go sharply higher, they lose.  Interestingly, Fed Chairman Greenspan was recently quoted as saying that premium bank charges for fixed rate mortgages — over the past decade or so — were higher than they needed to be to hedge that interest rate risk. In other words, during the low-rate period of the 90s, you were better off with an ARM than a fixed-rate mortgage.

But there’s no way to know if that will be true for the next 10 years. While rates are more likely to go up than down from here, there’s no way to know how high they’ll go. And one of the most important factors to consider is how long you plan to hold the loan. Few first-time homeowners stay in their house the full 30-year term, which means you may be better off thinking of a shorter time frame. There are, for example, variable-rate mortgages that lock you in for 3, 5 — sometimes 7 years. These ARMs typically offer lower rates than a 30-year fixed rate. So you get the security of a fixed rate at a lower cost. If you decide to stay past the fixed term, you’ll have an ARM (if you don’t refinance).