The Statistical Relevancy of the 7/1 ARM vs. the 30 Year Fixed

nerd-223x300Each person’s personal circumstances and long term objectives determine the type of mortgage they choose. For the past couple of years, the clear favorite has been the 30 year fixed rate mortgage because the yield curve between short term and long term bonds has been flat.  When this happens, there is very little difference in the interest rates between adjustable rate mortgages (ARM’s) and fixed rate mortgages.  But things are changing.  That yield curve is bending and significant differences between fixed rate mortgages and ARM’s are emerging.  What’s more, people are becoming more and more mobile.  Consequently, they don’t need as much interest rate security as they did in the past.

First, let’s pinpoint the current average life of a mortgage loan.  To do this we need to know how quickly, from a statistical standpoint, people pay off their 30 year fixed rate mortgages.  While this varies depending on interest rate, we’ll focus on low rate fixed rate mortgages for the sake of illustrating a point (since higher rate mortgages are paid off even more quickly than the one we’ll use in our comparison).  On page 12 of the Office of Thrift Supervision’s Selected Asset and Liability Price Tables (As of March 31, 2011), shows a WAC of 5% with a base pre-payment rate of 17% (WAC is the weighted average coupon of the underlying collateral or mortgages. To approximate the pass-through rate to the consumer, subtract 50 basis points – so these rates are in the mid to upper 4’s as far as interest rate is concerned).  So you’re thinking, . . . “what’s your point nerd?”  Well, if you take 100 and divide it by 17 you get 5.88 years and that’s the average life of a fixed rate mortgage in the mid to upper 4’s these days.  Kinda shocking eh?

What’s more shocking is how much money is forfeited by choosing a 30 year fixed rate mortgage over an ARM.  Statistically speaking, 3/1 and 5/1 ARM’s don’t offer enough rate security.  The 7/1 and 10/1 ARM do the trick though.  Consider this table (using the average loan amount in MN of 146,944 (224,000 * 65.6% = X):

Loan Program 30 Fixed 7/1 ARM
Loan Amount 146,944.00 146,944.00
Note Rate 4.375 3.375
Monthly Payment 731.00 647.81
Payment Savings over 5.88 Years 5869.89
Payment Savings over 7 Years 6,987.96
Amortization Savings over 5.88 Years 2538.24
Amortization Savings over 7 Years 2,947.15
Total Savings over 5.88 Years 8408.13
Total Savings over 7 Years 9,935.11

With potential savings in the range of $8408.13 and $9935.11, the decision between a 30 year fixed rate mortgage and a 7/1 ARM can be a very expensive one and shouldn’t be taken lightly.  Personal circumstances might dictate the appropriate loan type (15  year fixed, reverse mortgage and so on, . . ) but all too often, people jump right in on shopping for rates and closing costs on a 30 year fixed rate mortgage before asking themselves if they’re paying too much for interest rate security they may not necessarily need.

THIS POST WAS GIVEN ATTENTION ON NATIONAL PUBLIC RADIO’S MARKETPLACE MONEY:

Charles Dailey – Branch Manager, Loan Officer, Certified Military Housing Specialist – CA DOC, MN DOC & WI DFI

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Comments 5

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    Charles Dailey

    I was recently asked, “How many years of 1% rate increases would it take to eat away the $9,935 saved in the first seven with the 7/1 ARM?” It’s a great question. I thought I’d leave the answer on this post should others wonder the same:

    “Firstly, the 1% rate increases yearly would apply to a FHA 5/1 ARM which wouldn’t be a good one to bring into this article (plus 5 years of rate security is statistically insufficient). The 3 caps on a 7/1 ARM are typically 5/2/5 and are explained in the second paragraph of this link: http://www.iloanhomemortgage.com/fixed-period-adjustable-rate-mortgages-arms/. So, there are two ways of looking at this, (1) how long would it take you to lose back what you saved assuming the worst case scenario and (2) what would the expected rate be and how long would that take to break even? These are complicated calculations but doable. The worst case first adjustment on this 7/1 ARM would bring the rate up to 8.875 generating a payment of 1160.57 which is 429.57 higher than the 30 year fixed rate mortgage. If you divide the 7 year savings by 429.57 you’ll get 23.13 which is the number of months it would take to lose back the savings against a 30 year fixed rate mortgage. So essentially, the breakeven would be 8.927 years in a worst case scenario (after adding in the first 7 years). Now, what would the expected average rate be? Nobody can know but the best indication would be by looking at the last 10 years of the history of the index (http://www.moneycafe.com/personal-finance/libor/), averaging it (2.88%) and then adding it to the margin of the loan (2.25%) which gives you an average rate of 5.13%. If the rate were to average 5.13 percent, that would yield a payment of 66.14 more than the 30 year fixed. If you take the 84 month savings on a 7/1 arm and divide it by that payment differential, you get 150.21 months or 12.52 years. Add that to the first 7 years and the breakeven would be 19.52 years on that rate. So the answer would be somewhere between 8.93 years and 19.52 years depending on how you look at it.”

  3. Pingback: The Statistical Relevancy of the 7/1 ARM vs. the 30 Year Fixed | The Duckwall Team and The Twin Cities Real Estate Radio Show

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