Choosing a Variable Rate is like Ordering a Pizza

Mortgages can be confusing, but sometimes there are simple answers to tough questions like this one:

"Should I pick an adjustable rate mortgage, like a 3/1 or 5/1 ARM, or go with a 30 year Fixed Rate?"  How many times has a buyer or borrower asked you that question?  How do you help them choose in a way that makes sense to them?

I've found that "Pizza" is the best illustration to use to help them understand this question.  If I give this illustration, it all of the sudden makes sense to a borrower and allows them to make an informed and confident decision.  Here's what I'm talking about:

When you go in to a pizza parlor to order a pizza, you have to decide "What Size" to choose.  Some places have only a couple of sizes to choose from, other places have as many as 6 sizes to pick from.  How do you choose?

"If you're looking to get maximum value for your money..."

Well, if you're looking to get maximum value for your money, you can start calculating the cost per square inch of each size.  Since pizzas are round, you'll have to pull out your handy geometry cheat sheets (I can still see mine faintly etched on my forearm - where I wrote down the formulas to help me get through those high school math tests) to get through the diameter, radius, pi-r-squared issues.

You'll soon discover that in most pizza places, the larger sizes cost you less per square inch than the smaller sizes.  (This is why, when buying for large groups, you avoid buying individual personal-sized pizzas for each person and instead go for the largest sizes for everyone to share.)  

"Why would you EVER buy a smaller size?"

After you've figured out that you get more value per square inch out of the largest sizes, why would you EVER buy a smaller size?  The answer, when buying pizza, is obvious to you.  If you're by yourself, for example, and buy an extra large pizza because it's the best per-square-inch value, but eat only a few slices and throw the rest away - you've wasted your money.  Yes, you bought the best "total" pizza value, but by NOT USING the entire pizza - you wasted your money.  

The answer to your pizza buying size question, therefore, comes down to "How much pizza will I use?"  To get the most for your money, you should always buy the largest size you will actually use.  And so it is with choosing a mortgage ARM or Fixed Rate product.  Huh?

The assumption I will ALWAYS use when comparing an ARM with a Fixed Rate mortgage is that over the entire 30 year term, the 30 year Fixed Rate loan will cost you less than an ARM - which tends to start out with a lower interest rate for a few years and then will eventually adjust higher.  So if you're going to keep the loan for the entire 30 year period, a 30 year Fixed Rate loan is - just like the extra large pizza - the best value per year (per square inch).

BUT, if you take out a 30 year Fixed Rate loan and only keep it for a few years, it is just like buying that extra large pizza, eating a few slices, and throwing the rest away.  If you ABSOLUTELY KNOW that you are only going to keep that mortgage for a few years, then you need to give serious consideration to choosing an ARM if the rate you can get is less than the 30 year Fixed Rate.

A final word of caution:  Be sure to buy ENOUGH pizza to start with.  It is not good to find out you don't have enough to feed everyone because it is a hassle and expensive to go back and order some more after people have already started eating.  Likewise, be sure to get ENOUGH term on your ARM to start out with.  If you think you'll stay in the home for 3 years, but aren't 100% sure, you may want to get a 5/1 ARM to start with - just to be sure you'll have enough.  

Don't get caught short - almost EVERYONE expects rates to rise significantly in the future, so don't get stuck with a house payment you can't afford.

photos by: David de Groot & Randy Son of Robert