Which Is Better, A Fixed Rate Mortgage Or An Arm?

It depends on your risk tolerance.  If you are the type of person who wants, in essence, to buy insurance to assure that your home mortgage expense will not spike upward because of an inflationary surge, then borrow via a fixed rate mortgage.  This will protect you to the extent that the market rate of interest increases significantly in the future.  As discussed earlier, you will pay for this protection because the fixed rate of interest established at the inception of the loan will be significantly higher than that established at the inception of an ARM of comparable term.

What do I think?  In the past I have leaned more toward the ARM and have used ARM mortgages on the two homes I have purchased.  In economic cycles, the higher the inflation rate, generally the higher the market rate of interest.  Since the mid-1980's, when the Reagan Administration and Federal Reserve policy checked prior high inflationary trends, inflation has been held in check and has been virtually non-existent.  Similarly, market rates of interest have been stable or trended downward over that period of time.  Since I strongly believe that the Federal Reserve has established an infrastructure to prevent significant inflation, I am not fearful of significant rises in the market rate of interest in the future.

Let's look at me as an Example.  My wife and I purchased the house we now live in 1989.  We financed the purchase price through an ARM indexed to the less volatile, National Average Contract Interest Rate for Mortgage Lenders on the Purchase of Previously Occupied Homes, mentioned earlier.  Although hindsight is 20/20, I still think it is a useful exercise to look at how much money my wife and I saved using an ARM over a fixed rate mortgage with regard to our home.

Example:  In my and my wife's case, the interest rate at the inception of our ARM was 9.5% when the interest rate on a fixed rate mortgage of comparable term was 11%.  Since 1989 the interest rate has readjusted every year in a distinct downward trend.  For example, the annual readjustment of the interest rate saw the initial 9.5% rate drop to 6.0% level a few years ago.  Each year that the interest rate dropped by 1%, my wife and I saved approximately $1,500 in our annual mortgage payments. If we had originally taken out a fixed rate mortgage and never refinanced it, our cumulative mortgage payments over the last 12 years or so would have been tens of thousands of dollars greater.

Despite my historic leaning toward ARMs, the market has recently changed somewhat relative to fixed rate mortgages.  Historically, fixed rate mortgages have been priced at one and a half to two percentage points of interest above a fully-indexed ARM.  Recently, fixed rate mortgages have been priced as low as one-half a percentage point above some fully-indexed ARMs.  If you can get a fixed rate mortgage priced that close to an ARM, I would be inclined to go in that direction.  What you need to do is run the numbers both ways, making sure you factor in all variables and closing costs, and then make an informed decision based on your risk tolerance.