Interest costs are a drain on any financial plan, so it’s understandable that consumers would seek to minimize them. For many, this means finding the lower interest rate and/or the shortest loan term. But there are other options, especially for home mortgages. And in specific circumstances, what at first appear to be higher-cost or riskier loans may be cheaper and provide additional economic benefits.
The primary advantage
Here are two alternatives to fixed-rate mortgages which are seeing a resurgence in the US market.
Adjustable-rate mortgages, or ARMs, have monthly payments that fluctuate as interest rates go up or down. Most ARMs have an initial fixed-rate period, typically five to seven years, during which the rate doesn’t change, followed by rate changes occurring at preset intervals. New interest rates are typically calculated by adding a fixed margin to a financial benchmark, such as the London interbank offered rate (LIBOR). While currently comprising less than 5 percent of all mortgages in the United States, the adjustable-rate format is so common overseas that the phrase “adjustable” isn’t even used; they are just called “mortgages.”
One of the attractions of an ARM is that the initial interest rate will generally be lower than a comparable fixed-rate loan. And if interest rates are lower when the fixed-rate period ends, future monthly payments will decline as well.
But interest rates are unpredictable, and currently near historic lows. If they climb during the mortgage term, the total interest costs in an ARM might far exceed those in a conventional fixed-rate mortgage. Even though most ARMs have caps that limit how much a monthly payment can increase during an interval, the aggregate costs could significantly exceed a fixed-rate mortgage locked in at today’s rates.
In this arrangement, a borrower’s monthly payments reflect only the interest charged each month on a fixed-rate loan; there is no amortization, so the balance doesn’t go down. After a specified period, usually five to seven years, the borrower must either refinance the property, pay the balance in full, or begin an amortized payment schedule (resulting in significantly higher monthly payments).
Interest-only loans are less common, and rarely advertised; borrowers may have to ask if interest-only options are available, and meet higher eligibility standards. Compared to conventional mortgages, interest-only borrowers must have lower debt-to-income ratios, higher credit scores, and larger down payments.
Because monthly payments do not reduce the loan balance, lenders may charge a higher interest rate. But even at a higher rate, the interest-only monthly payment may be substantially less than a fixed-rate payment of principal and interest.
Long-Term Financial Certainty vs. Short-Term
For borrowers, a fixed-rate mortgage offers financial certainty – in monthly payments, the costs of borrowing, and when the loan will be paid off. The other options, not so much. An adjustable-rate mortgage, taken to its conclusion, will still pay off the mortgage. But the cumulative interest costs will only become evident as rates increase or decrease. Interest-only loans are a temporary transaction, with only one certainty: the borrower knows that another transaction – a sale, a payoff, a refinance – must occur when the interest-only period expires.
Besides the monthly cash-flow advantages, other factors play a part in determining if alternative mortgage arrangements are desirable. In the context of their larger financial objectives, the current home may not be an integral asset for every homeowner. For example:
A Home as a Temporary Residence: For homeowners who anticipate moving within a few years, the “what-ifs” of an ARM’s changing interest rate, or the need to refinance an interest-only loan are non-issues; the house will be sold, and the mortgage paid off. At the beginning of the term, the monthly payments
A Home as a Subsidized Rental: Under current tax law, mortgage interest is deductible for many households. In some instances, this deduction can make owning cheaper than renting, especially for families with children, where the primary options are buying or renting a single-family home. In a fixed-rate mortgage, the interest deduction declines over time as more of each payment goes to principal. Although the monthly payment will probably be lower, the full amount can be deductible for the entire period of an interest-only mortgage.
When a homeowner anticipates selling the property (after the children are grown, at retirement, etc.) the mortgage format to use might hinge on which strategy projects to deliver the most cash at the time of sale. If the monthly savings from an alt-mortgage can earn more than the cost of borrowing on a fixed-rate loan, the math favors the ARM or interest-only format. These “extra” savings can deliver additional financial benefits as well, such as increased liquidity and diversification. (And remember, even with no pay-down of principal, rising property values can increase a homeowner’s equity.)
Of course, this discussion is a waste of time if the borrower doesn’t save the difference.
If an alt-mortgage intrigues you, a conversation with a financial professional might help you determine how these formats could fit your unique circumstances.