Federal Reserve Chairman Alan Greenspan said Monday that many people are paying more for their homes than they need to by choosing fixed rate mortgages (FRMs) over adjustable rate mortgages (ARMs). He went on to say that U.S. household finances appeared generally sound, even though debt levels and bankruptcy filings are increasing.
"Overall, the household sector seems to be in good shape," he said.
Fixed rate mortgages carry a constant interest rate for the life of the loan, usually 15 or 30 years. ARMs offer a low fixed interest rate for an initial period, often one, three, or five years, and then typically adjust according to current market conditions once a year after that. The rate can adjust up or down, but will never go below the intial low rate. Today you might get a 30 year fixed rate of 5.5%, while a 5/1 ARM (5/1 means fixed for 5 yrs, adjusts once per year after that) might be 4.375%, or 3.5% for a 3/1 ARM.
Most borrowers choose the higher payment of a FRM in exchange for the security of knowing the interest rate will never go up.
According to one Fed study, many homeowners could have saved tens of thousands of dollars over the past ten years if they had gone with ARMs. Of course, that's easier to see with hindsight. Nobody can guarantee what interest rates will do in the future.
My recommendation is always based on a borrower's specific situation. ARMs have limits on how much the rate can go up - usually 1-2% per year, and 5-6% over the life of the loan. In the worst case scenario, where the rate goes up the maximum allowed each year, the break-even point on a 5/1 ARM is usually around 7 or 8 years. So if you plan to sell the house in less than 7 years, or refinance or pay off the loan, then save some money by choosing an ARM. If you plan to live there long term, then the security of a fixed rate might be better.
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