Mortgages with adjustable interest as a percentage of total loans: so low!

Since 2009, I have been encouraging Financial Samurai readers to take out a floating rate mortgage rather than a 30 year fixed rate mortgage. The rationale was that we were in a declining interest rate channel, so why pay more interest if you don’t have to?

Furthermore, the average length of home ownership in 2009 was only about 5-7 years. Therefore, it was illogical to take out a more expensive mortgage for a much longer fixed-rate period. Today, the average home ownership term is 10+ years as the demand for real estate has skyrocketed.

Because I practice what I preach, I’ve taken out multiple variable-rate mortgages (ARM) over the past 13 years, saving more than $300,000 in mortgage interest costs. In fact, my existing main residence mortgage is a 7/1 ARM at 2.125% closed in 2020. Score!

Although I had thought all along that I had made a difference by helping people save money on their mortgage payments, my message turned out to be ignored and fell on deaf ears!

Adjustable-rate mortgages as a percentage of total mortgages

Take a look at this great chart, compiled by Rick Palacios of JBREC. It shows that floating rate mortgages as a percentage of total loans are only 4.7%! Holy hell! I would have thought the percentage was closer to 25%.

In other words, the vast majority of mortgage lenders have a 30-year mortgage and to a lesser extent a 15-year mortgage, which I like.

Percentage of adjustable-rate mortgage loans relative to the total number of loans

Why has the percentage of adjustable loans shrunk so much?

The percentage of floating rate mortgages relative to total loans shrank from a high of about 34% in 2005 to less than 5% in 2022. The decline started when the housing market peaked around 2006 and reached a low of about 2 in 2009. .5%.

Adjustable loans declined in popularity because of:

1) A major slowdown in housing demand

2) Falling interest rates, resulting in lower 30-year fixed-rate mortgages

3) Decrease in house prices, making houses more affordable with fixed-rate mortgages

4) A reduction of mortgage and interest rate risk by banks

5) Emphasis from mortgage lenders, experts and advisors to take out a 30-year fixed-rate mortgage

6) The desire for predictability and comfort because of irrational fear

Don’t try to be contrarian with mortgages

I have not advised readers to take an ARM to buy a house in order to rebel or gain attention. My #1 goal has always been to help you save more money and earn more money so you can do what you want.

Since 2009, taking out an ARM has been the absolute right decision. If you took out an ARM, you paid on average at least 1% lower rate than if you took out a 30-year fixed-rate mortgage. On an average $300,000 mortgage, that’s $3,000 a year in gross annual interest savings or $30,000 in savings after 10 years.

Furthermore, before your ARM reset, you most likely could have refinanced your ARM to another ARM for the same or a lower rate, at little to no cost. Or you could have let the introductory fixed-rate period of your ARM expire. If so, your new rate would likely have stayed the same or decreased.

I used the $300,000+ in mortgage interest savings since 2009 to invest in stocks and real estate. Those investments have allowed me to increase my passive income by ~$30,000.

Below is the 40-year downward trend in 10-year US Treasury yields. Do you really want to bet against a long-term structure trend? new.

Ten-year US Treasury yields on a downward trend since the mid-1980s

ARM or 30 years stuck in a rising interest rate environment?

So what should homeowners or prospective homeowners do now that we’re in a Fed rate hike cycle? The most rational answer is to match or repay the term of your home with the fixed term of the mortgage loan.

In other words, if you plan to own your home or pay off your mortgage in 10 years, you’ll get a 10/1 ARM. If you plan on taking 28 years to pay off your home, you may be better off taking a 30-year fixed-rate mortgage.

That said, I still recommend an ARM for a 30-year fixed-rate mortgage, even if you plan to own the home or take longer to pay it off.

Here’s the main reason to take out a floating rate mortgage:

Mortgage rates can rise during the fixed-rate period of your ARM. But chances are high mortgage rates will fall again before your ARM resets. The most common types of ARMs are 5/1, 7/1 and 10/1 followed by 3/1. The longer the introductory period of your ARM, the more likely the mortgage interest rate will go down again before the reset.

Even if the mortgage interest rate is higher in the first year of a reset, you have paid off part of your principal. As a result, a lower principal balance will help offset the higher interest.

You also saved money for the entire duration of the introductory fixed-rate period, which forms a buffer for higher rates. Finally, you will probably make more money in the future.

Example mortgage interest comparison

Let’s say I’m taking out a $1 million 7/1 ARM with a value of 3.5% versus a 30-year fixed-rate mortgage of 4.5%. In seven years, I’ve saved $70,000 in gross mortgage interest.

If my ARM goes back to 4.5% after the seventh year, I’ll pay the same interest if I had taken a 30-year fixed-rate mortgage, a good option.

If my ARM rate resets by 2% to 5.5%, I have seven years at 5.5% before getting a 30 year would have saved me money. A 2% increase is about the most I expect mortgage rates to rise.

However, there is a greater than 80% chance that sometime in this 14-year period before I start making a loss, I would have sold the property, seen the mortgage rate fall again, or paid off the mortgage. In the 20% chance I still have the mortgage, the principal would probably be 30% lower.

Average home ownership

A 30-year fixed-rate mortgage is overrated

When you buy a house for the first time, do you really think that the first house you buy will be your forever home? Of course not! You will probably make more money, start a family or move for a job and buy a nicer house. That’s why getting an ARM is better for newer home buyers.

If you’re an experienced home buyer, do you think taking out a 30-year fixed-rate mortgage will give you more peace of mind? Probably not if you realize you’re paying a higher interest rate than you need to. Since you are older, you are probably richer with many more financial alternatives. This allows you to afford to save money on your mortgage.

Let’s say mortgage rates keep rising to the moon. My 2.125% 7/1 ARM looks like it will reset to 6% in the year 2027. What should I do?

I’ll just pay my mortgage as usual until 2027 with no additional principal payments, especially since the real mortgage interest rate is negative. Then over the years I will put aside reserves to pay off some or all of the principal balance before having to pay 6%. There’s no way you’ll make me pay a 3x higher interest rate!

The percentage of loans with adjustable interest should be higher

The percentage of adjustable-rate loans relative to total loans is likely to increase because everyone is rational and wants to save money. With higher house prices and higher mortgage rates, more buyers will try to save by taking out ARMs. I suspect the adjustable loan percentage will rise to 10%+ in the next three years. And if all borrowers read Financial Samurai, I think the percentage would go up to 50%.

If you take out a mortgage with a fixed-rate period of 30 years after a sharp interest rate rise, you are locked into higher rates for a long time. That’s like admitting defeat. Instead, by getting an ARM, you lock in a mortgage rate for a shorter duration, pay a lower interest rate, and have the chance to refinance at a lower interest rate in the future.

A variable rate mortgage will likely save you money over a 30 year fixed rate mortgage. And there’s nothing I like more than saving money while investing in my favorite asset class.

Readers, are you surprised about adjustable-rate loans because the percentage of total loans is so low? Why do so many people like to take out a 30-year fixed-rate mortgage at a higher interest rate?

If you are looking to refinance or get an adjustable rate loan, go to Credible. Credible is a leading mortgage lending platform where half a dozen qualified lenders compete for your business. Requesting a real mortgage quote is free. Mortgage rates are actually falling again.

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