The mortgage rates today are a lot higher than they were a couple of years ago. They are still not considered high by historical standards, but it is painful for someone who needs a new mortgage today because of the big difference from the recent past.
I was incredibly lucky to have refinanced in very early 2021. I got a 15-year mortgage at 2%. I am often an advocate of paying down the mortgage (with certain exceptions) during more normal times, but it does not make much sense for me to pay extra on a 2% loan. I can easily get a better return on a cd or Treasury bill, even accounting for taxes.
As of this writing, a 30-year fixed rate mortgage would have an interest rate around 7%. A 15-year fixed would be a little under 6.5% for most people.
If you look at a 5-1 ARM, the rate is a little below 6%. This means the rate would be fixed for the first five years before adjusting. So for the first five years, this is the best deal.
If you are buying a house that you are likely to sell in the next 5 years, then this would make more sense than a regular fixed-rate mortgage. But I don’t recommend doing this in most situations due to the high transaction costs of buying and selling real estate.
Which Direction Will Interest Rates Go?
Your guess is as good as mine.
The price inflation significantly above the 2% mark indicates that rates could go higher. If the Fed has to keep a tight money policy to fight inflation (that it created), then this could mean even higher rates.
On the other hand, the yield curve is highly inverted, mid-size banks are failing, and a recession looks highly likely in the next year or so. This points in more of a direction of lower rates. If price inflation isn’t too much of a problem, then investors will seek safety in U.S. bonds, which will drive rates down.
It is hard enough to figure out where rates will be in a year or two. If we knew this for sure, then we could get rich playing the bond market. It is even harder to take a good guess where rates will be in five years or more when a mortgage might adjust.
Therefore, you shouldn’t really take this into consideration when making a decision. Even though it is the only factor that will ultimately make it a good or bad decision to get an adjustable rate mortgage, it is a complete unknown. So the decision has to be made on the assumption that either scenario will happen.
Budgeting for the Worst
One way to decide is to figure out the worst-case scenario if interest rates are higher 5 years down the road. Will the higher mortgage payment be crippling, or could you still handle it?
Getting the fixed-rate mortgage is really a form of insurance against higher interest rates. You are locking in the sure thing.
Beyond your monthly budget, which is also hard to predict five years down the road, your overall financial picture does matter.
Some people have savings, but they don’t want to drain everything in order to not take on a mortgage. But five years down the road, maybe you will have enough saved to pay off or significantly pay down your mortgage. If you get the balance low enough at that point, then the higher rate may not matter that much to you.
Most people are not in this situation though, so a fixed-rate mortgage tends to make more sense. Also, if rates drop a lot, then you can always refinance.
Right now, the difference between a fixed-rate mortgage and an adjustable-rate mortgage is not that significant. It probably isn’t worth the risk to most people to get the 1% better interest rate with the unknown risk after five years.
Waiting to Buy
Right now is a terrible time to refinance. Unless someone had really bad credit with a really bad rate, then refinancing doesn’t make sense for most people. Rates are higher now than they have been in a long time.
But what if you are purchasing a new house?
My first recommendation is to wait. Even though we are in an inflationary environment right now (in terms of consumer prices), we are also likely in a bubble. Housing is part of that bubble in most places.
There is a good chance that prices will fall in the coming few years.
There may be some good bargains at that time, at least compared to what we see now.
It seems like a terrible time to buy a property because prices haven’t fallen much, but interest rates are much higher, which makes the monthly payments higher.
The exception, of course, is to someone who has the money to pay for a house without taking on a mortgage. Then you are in the driver’s seat. You can also get a better price with this negotiating power.
It still might make more sense to wait for prices to fall in this case, but at least interest rates don’t matter if you don’t need a mortgage.
For most people, it probably makes sense to wait to buy, but it always depends on your personal situation. If you are going to buy, it likely makes more sense to get a fixed-rate mortgage for 30 years. You can always refinance later.