Fixed Rate v Adjustable Rate Mortgage

I’ve had several clients recently ask me about Adjustable Rate Mortgages. This is for those who are considering mortgages on homes. Let me start by quoting one of the greatest businessmen and thinkers of all time, the great John Malone:

“The cable industry created so many rich guys. It was the combination of tax-sheltered cash-flow growth that was, in effect, growing faster than the interest rate under which you could borrow money.” “Inflation lets you raise your rates and devalue your liabilities.”

Interest rates are at an all time low. They will rise over time. Inflation currently is at 2.8% annually. Every year you hold a fixed rate mortgage the liability gets devalued 2.8% while the value of the property should increase at least by the rate of inflation. This is a 5.6% annual increase in wealth annually. You might say, ” but I have to pay higher interest payments?”. The current spread between a fixed rate mortgage and a adjustable rate mortgage(7/1 ARM) is approximately .8% but the government is going to help subsidize this by giving you an interest deduction. In the highest tax bracket this reduces the after tax rate by 45%. The after tax difference is (3.8%-45%)-(3.0%-45%)=2.09%-1.65%=.54%(assumes the first couple of years is mainly interest). On a $750K mortgage this amounts to $4,050 annually in the first seven years.

Now let’s model this over time. If interest rates stay the same after year 7 and the reset on the ARM doesn’t change for the next 23 years then a bet to do an ARM works in your favor. This is highly unlikely; worse you have no hedge against rising inflation and therefore interest rates. Let’s say the ARM resets .25% a year after year 7, to a maximum of 6% (which is highly likely). Even though you pay more interest in the first 7 years with the fixed rate option, you still pay $565,000 in interest on the ARM over the 30 year life of the loan. You will pay $508,000 in interest over the life of the fixed rate mortgage. The break-even for the ARM adjustment is approximately 4.7%. Meaning that both loans will cost you $508K in interest over 30 years if the ARM after 7 years doesn’t adjust any higher than 4.7%.

The fixed rate is the better option because it is likely less expensive. Additionally, the fixed rate mortgage gives you a hedge against rates rising higher than the 6% that is modeled above. There are very few fee lunches in financial planning. The low rate fixed rate mortgages that are available today is a free lunch.