Given inflation and mortgage rates have gone up aggressively since August 2020, was getting an ARM back then a bad move? Maybe. But I’ll argue probably not. Let me reason why.
One of the best things about running Financial Samurai is having readers criticize my financial beliefs and actions. So long as the criticism is respectful, I find the criticism to be one of the best ways to learn. After all, if we’re stuck in an echo chamber, it’s hard to outperform.
Now that we’ve seen big rises in inflation and mortgage rates, I’ve received a couple of comments saying that I was wrong for sticking with my ARM recommendation call. It’s always easier to point out mistakes after the fact.
For reference, I’ve been writing about how an adjustable rate mortgage is preferable to a 30-year fixed rate mortgage since 2009, when the 10-year bond yield was at ~4%. I’ve actually held this belief since 2004, five years before I started Financial Samurai. Today, the 10-year bond yield is at ~2.85% after rebounding from a 0.52% low in 2020.
In other words, my public call to get an ARM and save on mortgage interest expense has been correct for at least 13 years. Could the 14th year in 2022 really be when I finally got my call wrong?
In the world of “what have you done for me lately,” let’s do some analysis!
Argument For Why Taking Out An ARM Is Bad Advice
First, let me share the latest criticism that motivated me to write this post. Deon writes,
“I have been a long-term subscriber and like most of your comments. I even invested in Farmland through your site. What boggles my mind as a 30+ real estate investor is HOW on earth were you advising folks to refinance into 5-7 year adjustable rate mortgages when rates for a 30-year FIXED were at in the mid 2.5% again FIXED.
That is simply insane advice. It was FREE money for 30 years. There is no other way around that fact EVEN if would you were to sell in 3-5 year timeframe to avoid or reduce capital gains. These were ridiculously LOW rates to give people option to NOT sell. Really BAD advice and sorry have to call you out that one.”
I’ve always thought I was in the business of writing, where I share my thoughts freely (bad business!). But if I’m in the advice-giving business, I should consider charging. But it’s always easier to offer refunds when everything is free.
Mortgages By Interest Rate
If Deon was able to get a 30-year fixed-rate mortgage at 2.5% that is a fantastic rate. Back in 2020, the lowest quotes I could get for a jumbo 30-year fixed was around 2.75%.
Roughly 8.8% of mortgage holders have a mortgage interest rate at 2.5% or less. So if you got a 30-year fixed-rate at 2.5% or less, consider yourself special and lucky.
Here is a break down of mortgages by interest rate.
If I was able to get a 30-year fixed-rate mortgage rate at 2.5%, I’d be very tempted to lock one in as well. It’s a phenomenal rate for 30 years of peace of mind.
However, if I could get a 2.5% quote for a 30-year, I could also probably get a 1.75% quote for a 7/1 ARM. If so and if I went with the ARM, I would still be saving 0.75% in interest expense a year for seven years over a 30-year fixed mortgage.
An Adjustable Rate Mortgage Has An Interest Rate Cap
Once the introductory fixed-rate term expires, an ARM has an interest rate cap, usually no more than 2% the first year (from 1.75% to 3.75% in this example) and 1% every following year (from 3.75% to 4.75%, etc). An ARM also has a lifetime interest rate cap, usually no more than quadruple the rate. In this case, the maximum interest rate would by 7%.
If you do the math, the 30-year fixed rate mortgage would start becoming a better deal at about year 10, or three years after the fixed-rate period is over. But this is only if mortgage rates rise by over 2% in year eight and stay higher by 3% in year nine and later.
At the moment, two years after Deon said he could have gotten 2.5% on a 30-year fixed, we have experienced a ~2%+ increase in mortgage rates. But will inflation stay at 40-year highs for another six years? I don’t think so.
A person who took out a 7/1 ARM in 2020 that expires in 2027 doesn’t really care if interest rates rise by 10% today. Even in year eight, if mortgage rates are still 10% higher, the most the 1.75% ARM can go up is to 3.75% and by 1% every year until the cap is reached at 7%.
I’m not sure if Deon or most people know this because most people don’t take out ARMs. Only about 10% of total mortgage holders have ARMs. The percentage was only about 5% before 2021.
Historical Mortgage Rates
Below are the average mortgage rates for a 30Y FRM, 15Y FRM, and 5/1 ARM from Freddie Mac.
Deon, the commenter, uses the all-time low as an example and then quotes 2.5% for a 30Y FRM, 0.27% below the all-time low average. Cherry-picking data to make your argument is a good strategy.
It is also a good test for the counterargument, which I’m providing.
Average Homeownership Duration
Let’s continue to assume the worst-case scenario for the ARM holder, that interest rates surge higher soon after taking out an ARM and stays higher for years.
In 2020, the average U.S. homeownership tenure was about eight years. To favor the 30-year fixed-rate mortgage argument, let’s now assume the average homeownership tenure is closer to nine years in 2022.
If you are the average U.S. homeowner, you would sell your property after nine years. Therefore, the average U.S. homeowner who takes out an adjustable rate mortgage would still benefit from taking out a 7/1 or 10/1 ARM in a realistic worst-case scenario. Again, the break even point where a 30-year fixed-rate mortgage makes sense in a worst-case scenario starts at about year 10.
An 8-to-10-year average holding period for a home sounds reasonable. Most of us are getting wealthier each year and have desires to upgrade after 10 years. For folks like me, who suffer from real estate FOMO, 8-to-10 years might feel a little long.
For example, I just bought my “forever home” in June 2020 and I’m already itching to buy a nicer home with a great floor plan. By 2027, when my 7/1 ARM resets, the loan balance will likely be at least 20% lower, providing an extra cushion in case rates are higher.
What Happens To Home And Rent Prices In A High Inflationary Environment?
The Fed hikes the Fed Funds rate in an attempt to curb inflation. High inflation is usually due to a strong labor market and a strong economy. What happens to property prices and rents in a strong economy? They usually go up. Inflation acts as a tailwind for property prices, while property prices are a component of inflation.
What people who criticize ARMs may be missing is how secondary the debate between getting an ARM or a 30-year fixed-rate mortgage is. The comparative gains in real estate values in a high inflation environment far outweighs the savings one could get from either type of mortgage.
The Rise In Property Values Dominates The Debate
For example, let’s say you purchased a $1 million property in May 2020, the bottom of the most recent real estate market cycle. March 2020 is when lockdowns began and public open houses stopped. May is around when sellers panicked the most.
If you bought a $1 million property in May 2020, by May 2022, your property was worth between 20% – 50% more, depending on where it is in the country. In other words, you’re up about $200,000 – $500,000 in two years.
Let’s say you got a $800,000, 7/1 ARM at 1.75% versus a 30-year fixed at 2.5%. Your annual gross interest savings because you took out an ARM is $6,000. Over two years, your annual gross interest savings is $12,000. Congrats for taking out an ARM in a rising-interest rate environment!
But $12,000 in gross mortgage interest savings accounts for only 2.4% to 6% of the $200,000 – $500,000 you’re up on your property. And after saving $42,000 in gross mortgage interest for seven years taking out a 7/1 ARM, are you really that worried if your ARM resets from 1.75% to 3.75%? Of course not. Your job income or rental income is likely much higher by then as well.
If inflation is still rocking at 40-year highs 10 years after you took out a 7/1 ARM, your property’s value has likely gone up another 50% – 120%. That’s another $600,000 – $1,440,000 in real estate equity gains! So you’re now paying a 5.75% mortgage rate in year 10 compared to only 1.75% from years 1-7. Your payment went up from $2,858 to to $4,669.
Paying an extra $1,811 a month sounds like a lot. But is it really if your property is up $800,000+ since 2020 and you saved $42,000 in gross mortgage interest expense for the first seven years you had your 7/1 ARM? Not really.
Thanks to inflation, your $4,669 monthly mortgage payment in year 10 won’t feel as bad as it sounds today. It will actually probably feel closer to the $2,858 mortgage payment you are paying today after adjusting for inflation.
The ARM May Have Made Homeowners More Money
Here is another consideration. Since taking out an ARM enables a buyer to more easily afford a home, an ARM could have made the difference in buying or not buying. Or an ARM could have enabled a buyer to buy a more expensive home than they would have with a 30-year fixed-rate mortgage.
So long as a buyer doesn’t pay more than 5X their household income for the price of their home, they are relatively safe in their home purchase.
Let’s see who wins in a housing bull market.
In a bull market, a person who bought a home with an ARM vs. a person who didn’t buy a home because they couldn’t afford to buy with a 30-year fixed-rate mortgage? The ARM holder.
In a bull market, a person who bought a home with an ARM vs. a person who bought a 10% cheaper home with a 30-year fixed-rate mortgage? The ARM holder.
Of course, the homebuyer with a 30-year fixed-rate mortgage since 2020 has also made a healthy return on their investment. They are just paying a higher mortgage interest expense. But again, a higher mortgage doesn’t really matter given the real estate returns since then.
Whether you borrow at 2.5% for a 30-year fixed or at 1.75% for a 7/1 ARM, you’re still borrowing “free money,” as Deon comments. The reason is because inflation at 8.5% is much higher than both those rates. The 7/1 ARM rate is just “more free” than the 30-year fixed rate as both are negative real interest rate mortgages.
Spending 30 Years To Pay Off Your Mortgage
If you want to spend 30 years paying off your mortgage, then getting a 30-year fixed-rate mortgage becomes more attractive. In this case, the peace of mind you are buying with a 30-year is more valuable.
Let’s say you have no ability to make extra income to pay down your mortgage quicker. You also don’t have any energy or ability to refinance your mortgage. Finally, you also believe we are in a permanently-high inflation and interest rate environment.
When you look at the below chart, you don’t believe in the 40-year downward trend in inflation since the 1980s. Instead, you believe inflation will go back to the 1980s level and stay elevated for at least a decade. The red line will keep on going up like a rocket ship!
If this is the case, getting a 30-year fixed-rate mortgage was and is appropriate. Don’t let me or anybody else tell you otherwise!
Happily Holding My ARM
Personally, I’m glad to have taken out a 7/1 ARM in 2020 for 2.125% with all the fees baked in. I firmly believe inflation and interest rates will resume their downward trend well before my introductory rate period expires in June 2027.
But in the 20% chance scenario I’m wrong, I’ll have several years after the introductory rate period is over before I start losing. But I don’t plan to lose. I plan to rationally pay down more mortgage debt if interest rates are higher. Or, I plan to refinance my mortgage to another ARM if interest rates dip again. I might even sell my home before 2030 and buy a nicer one.
As an ARM holder, I’m not afraid because above-trend interest rates and mortgages rates rarely last longer than three years. After three years, inflation and interest rates begin to fade once more.
The irony is, as a real estate investor, you want inflation to stay elevated. Not in the 8%+ range, but more in the 4% – 5% range. This way, mortgage rates will come down, demand for real estate will go up, and rents will continue to rise. You want to own and keep renting out your property in a high inflation environment.
I know I’m part of the 5% minority of ARM holders. For this reason, I’m viewed as an anomaly. I might also be viewed as stupid or taking excessive risks by those who’ve never taken out an ARM. It’s understandable to dislike what we don’t know.
But since taking out my first ARM in 2004 and refinancing multiple times as rates have come down, I’ve had a good 18-year run. I’ve saved more than $350,000 in mortgage interest since 2004. If I start to lose beginning in 2027, then so be it. But for now, I’ve got another five years of mortgage interest savings to go.
Make Your Own Mortgage Decision And Be Satisfied
You don’t have to follow my lead as our financial situations are different. Just make sure you run the mortgage numbers under various scenarios.
I just want to save and make the most money possible. And to me, matching your mortgage’s fixed-rate duration to the length of time you plan to own your home makes the most sense.
Based on my history, I have yet to let a mortgage last beyond 15 years. I’ve either paid off the mortgage, refinanced it, or sold the property. Hence, taking out a 7/1 or 10/1 ARM makes the most sense to me.
Readers, why do you think the majority of people still are against ARMs? Do you think there’s a correlation between financial knowledge and one’s views against ARMs? Please share what type of mortgage you got and why. Were you able to get a 30-year fixed-rate mortgage at 2.5%?
To go deeper into building greater wealth, pick up a hardcopy of my new Wall Street Journal bestselling book, Buy This, Not That: How To Spend Your Way To Wealth And Freedom. If you enjoyed this debate about whether to take out a 30-year fixed or an ARM, you will love the book as I tackle some of life’s biggest dilemmas.
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