Fixed rate versus adjustable rate explained

Price of money plus price of insurance

Lenders are really concerned about three things: money, insurance, and risk. On any given day there is a basic price for money, which is related to what lenders have to pay their depositors or the price at which they can sell a loan. That determines the lowest absolute cost to the consumer.

The insurance part of the price is what you pay for long-term rate protection. If you ask the lender to guarantee your rate for 1 year, you’ll get one price. If you ask for 15 years of protection, you’ll pay more, a premium based on how risky the market perceives the additional 15 years of rate protection. You can conclude that the 30- year fixed-rate mortgage would have to be the most expensive product the industry offers, and you’re right.

Finally, lenders assess the more obvious risk factors. The more risk the lender perceives, the more you pay. If a prospective borrower has a poor credit history, the lender perceives that it has a greater risk of not getting its money back, so the risk part of the price goes up. At higher loan-to-value (LTV) ratios, there is less equity to protect the lender’s interest, so the rate goes up.

Here’s the first lesson in choosing a loan: Buy rate protection only for the length of time you’ll be in the property. If you select a 30-year fixed-rate loan and you are in your home for only 7 years, you paid a lot of extra money for 23 years of rate protection that you didn’t need. How much is that? Well, the industry offers loans that are fixed for just 7 years, and they are priced approximately 1⁄2 percent below the 30-year fixed-rate loan. On a $200,000 loan, that 1⁄2 percent amounts to $1,000 per year. Choosing a 30-year loan initially instead of a 7-year loan would cost you $7,000. To easily dodge one of those expensive “risk adjustments,” buy rate insurance only for the amount of time you are going to be in the house.

Not every homebuyer knows this in advance, but many people do, and I just gave you 7,000 reasons to consider this carefully. Millions of people make this mistake simply because they don’t have someone like me to explain it to them.

Fixed rate vs. adjustable rate

The first question many people ask is, “Am I better off with a fixedrate loan or an adjustable rate mortgage?” The answer is twofold:

If you are in a period of rising interest rates, get a fixed-rate mortgage. Even though you’ll pay a higher rate initially, you’ll save in the long run when the rates move higher.
If rates are falling, get an adjustable rate mortgage.

That may sound too simple, but it’s true. Anyway, it’s the first issue to deal with. I can hear someone asking, “How do I know whether rates are rising or falling?” Well, I can’t predict the future any more than you can, and if you find someone who claims to, run, do not walk, in the other direction! However, I will point out that this is a cyclical world the tide comes in and the tide goes out. If rates are or have been high, the next move will probably be down.

Conversely, when rates have been down for a while, the next move will probably be up. You probably have a pretty good feel for where rates have been and where they are going. Trust your intuition, but try to avoid making an emotional decision that leads to an unwise choice. Let’s leave it at that.

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