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

Each 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):

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:

iLoan quoted on National Public Radio’s MarketPlace report on Adjustable Rate Mortgages – take a listen