ARM or Fixed Rate: Mortgaging for Stability

The health of the mortgage industry has made recent headlines, due both to the aftermath of Hurricane Sandy and the ongoing phenomenon of near-record low rates for both fixed rate and adjustable rate mortgages, or ARMS, But while these low interest rates make it possible to purchase income property at bargain basement prices, not all mortgages are created equal. The attractive but slippery ARM trapped numerous unwary homeowners into a morass of foreclosures, short sales and defaults in the recent housing crisis of 2008-2011, while the less glamorous but stable fixed rate mortgage plodded on, creating a steady financial return for an investors.

At first glance, ARMs appear to be a good option, offering financing at initially low payments. The ARM is a complicated type of loan that, on the surface, appears to offer a break for borrowers in a budget – but which proved to be a trap for many homeowners as the housing collapse expanded.

As its name indicates, the ARM is an adjustable rate mortgage, which means that after an introductory low rate such as the 2% currently being advertised, interest rate on the loan will begin to rise, adjusted according to an external benchmark such as certificates of deposit or Treasury bills. ARMs are issued for varying periods. But when held long enough, the rates may eventually exceed those of a fixed rate mortgage.

The initial low rates of the ARM attracted many potential homeowners before the housing meltdown of 2008-2011. These rates allowed buyers who would otherwise not have been able to finance a home to get mortgage payments they could afford. But when the initial constant low rate became adjustable, payments shot up, pushing many unwary homeowners with marginal finances into foreclosures.

Less glamorous but significantly less risky is the standard fixed rate mortgage. Even at today’s low rates, interest rates on a fixed rate mortgage are higher than an ARM of an equivalent term – around 3.5%. But these rates are locked in for the term of the mortgage – and a 30-year term offers the lowest payments.

Fixed rate mortgages are far less complicated than ARMs.

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Borrowers know what the payment will be every month, making it easier to budget. And for investors, this fixed payment is easier to cover by rental

income since it is predictable. With refinancing, investors can continue to keep payments stable while earning a return on the investment through rents.

As Jason Hartman points out, home equity is vulnerable, and paying off loans in order to own a house free and clear can place an investor at a disadvantage, such as in situations like the recent Hurricane Sandy, which damaged many homes in several states. Mortgage holders in those states became eligible for a mortgage holiday due to the crisis – a benefit not available to owners of paid-off properties.

Likewise, mortgage holders benefit from economic variables such as inflation, which can reduce the value of mortgage debt over time, and also from leverage opportunities unavailable to those who heed traditional financing advice and invest their own money into properties in an attempt to own them free and clear.

In the world of income property investing, ARMed can mean dangerous. But this type of loan is directly responsible for many of the foreclosures flooding the market in the aftermath of the mortgage crisis. If the ARM is the hare, the fixed rate mortgage is the tortoise – slow and steady, protecting against periods of instability and locking in rates for the lifetime of an investment. (Top image: Flickr | StockMonkeys.com)

The American Monetary Association Team


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