Real Estate and Financing Options

¶ … 30-Year Fixed Mortgage and a 5/1 Arm

There are many different types of mortgage loans available on the market. One of the most traditional is clearly the 30-year fixed mortgage; however, lenders provide other packages to suit the needs of other types of house buyers based on their long or short-term view. This paper will compare two types of mortgage loans -- a 30-year fixed and 5/1 Arm (a loan with the rate locked for the first five years but can only increase 1% with each subsequent year should rates rise). The reader will be able to understand the pros and cons of each type of loan package.

Scenario -- 6819 S. 42nd Lane, Phoenix, AZ (MLS# 4595517)

The house that we will use to conduct our comparative analysis is MLS # 4595517 (the link is http://www.realtor.com/realestateandhomes-detail/6819-S-42nd-Ln_Phoenix_AZ_

85041_M21586-12497) with the asking price of $169,999. Assuming a 20% down payment and funds to cover closing costs, the loan amount is $135,999.20. For illustrative purposes, we do not make any considerations regarding points, discounts or broker fees. Using the rates at Bankrate.com (retrieved June 16, 2011), a 30-year fixed is averaged at 4.5%. A 5/1 Arm is averaged at 3.04%. Using an amortization schedule, our mortgage payments on a 30-year fixed is $689.09 a month while on a 5/1 Arm, the payments are $576.32, already a savings of $112.77 per month on the mortgage. Over the first 60 months, the home buyer will save $6,766.20 versus purchasing the house with a 30-year fixed loan.

However, we have to ask the question, "What's the risk?" The 5/1 Arm, as stated earlier, is locked at the interest rate at 3.04% for the first five years, however, should rates rise, it can go up as much as 1% each year thereafter. To illustrate, consider the table below on the payments for a 5/1 Arm should the interest keep rising 1% for the next five years.

Table 1: 5/1 Arm Possible Scenario

Year Rate Monthly Payment

1-5-3.04% $576.32

6 4.04% $652.42

7 5.04% $733.40

8 6.04% $818.88

9 7.04% $908.46

10 8.04% $1,001.71

As one can see, if a borrower on a 5/1 Arm decides to hold the mortgage longer, then a possible scenario is the interest rates keep rising that by Year 10, the monthly payments will have almost doubled! The $6,766.20 in savings will quickly evaporate had the borrower committed to a 30-year fixed. Does this make the 5/1 Arm a bad choice? Not necessarily.

So between the two types of loans, which one should the borrower seek to obtain? For the 30-year fixed, a borrower should obtain this loan if 1) they have a long-term view of staying in the house for more than five years, 2) interest rates are very low, 3) have a conservative view on handling their finances and do not want to worry about refinancing options. This loan would not be a good to obtain if 1) the borrower does not plan to stay in the house for more than five years, 2) interests rates are already high, 3) the gap of the interest rates between the two types of loans is the difference of being able to qualify for the loan.