30 Year Fixed Rate Mortgages Favor the Bank, Not The Consumer, For Most Transactions
Have you noticed that the large retail banks have been pushing fixed rate mortgages? The reason is that the interest rate that the bank collects on a 30 year (4.125 %) is much higher than on a 5/1 ARM (2.625%) or a 10/1ARM (3.375%). For most homeowners, 30 year fixed rate mortgages are unnecessary because homeowners do not hold their mortgages for more than 5 to 7 years due to refinancing, selling or paying off early. The difference in the annual interest on a 1M loan is approximately $12,500 and $62,500 over 5 years. The numbers are approximately the same over 10 years for the 10/1 ARM.
The banks benefit by collecting an extra 87 to 135 basis points for 5-10 years knowing that the odds are heavily in the banks favor.
For the protection of the borrower, mid-term and long-term ARMs have caps. There are caps after the initial 5 or 10 year period and each year after that as well as a lifetime cap which reduces the exposure of the change. After the initial 5 or 10 year period, the rate of an ARM will adjust to the 1 year treasury + a margin of 2.75%. Currently the 1 year treasury is approximately 0.1 % so a rate changing today would be approximately 2.875 % for the next year.
Even if rates increase after the initial change, homeowners are usually prepared for the change and they realize that it was better to save the money in the early stages when they needed the cash more and their incomes were less. If buyers are concerned that their future income will be less and that they will not satisfy the mortgage through refinancing or selling, then they should focus on a higher cost fixed rate.
Homeowners should consider their options carefully before choosing a product which should be more beneficial to the client than the bank.