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Why are Fixed Rate Mortgages Beating ARMs?

Usually when we think of mortgage rates they have a certain order: the interest level for fixed rate loans is higher than the interest level for adjustable-rate mortgages.

While this is a general rule there are exceptions, including the rates seen last week. According to Freddie Mac, home loan rates looked like this:

  • 30-year fixed-rate mortgage (FRM) averaged 3.40 percent with an average 0.8 points.
  • 15-year FRM this week averaged 2.61 percent with an average 0.7 points.
  • 15-year Treasury-indexed hybrid adjustable-rate mortgage (ARM) averaged 2.58 percent this week with an average 0.5 points.
  • 1-year Treasury-indexed ARM averaged 2.62 percent this week with an average 0.3 points.

If you look at these general national rates, rates that can vary somewhat across the country, you can see two interesting numbers.

Fixed Rates Beating ARMs

First, each loan option is shown with a percentage mortgage rate as well as a figure for points. "Points" represent money paid up front to the lender. One point is equal to 1% of the amount borrowed. If you borrow $100,000 a point would be equal to $1,000. If the cost of a point is 0.5 then the lender would collect $500 at closing.

A look at the figures above show that various combinations of rates and points are available, depending on the preference of the borrower.

Second, if we look just at the rates then there is a curious situation: the interest rate for a 15-year mortgage is less than start rate for a one-year ARM. In fact, the Freddie Mac figures show that the cost of a 15-year mortgage is just 0.3 percent lower than a five-year ARM.

This is not something you see very often. Here we have a situation where a fixed rate for the life of the loan is lower than the start rate for an ARM, a rate which may rise or fall in the future.

Why are the rates for 15-year financing so low?

Consider Your Options

One reason must be that lenders see very little risk in the coming decade or so. Because 15-year mortgages are paid down so fast, the risk to the lender quickly declines, meaning there is less to worry about and that the loan can be justified even with lower rates.

However, while the rates for 15-year financing might be lower than for the one-year ARM, its actual monthly cost is higher.

Let's say that the VA loan amount is $150,000. The one-year ARM at 2.61 percent will have a monthly cost for principal and interest of $601.30. The 15-year fixed-rate loan at 2.58 percent will cost $1,005.84.

If the rate for the 15-year loan is lower than the ARM, why is the monthly cost so much higher?

The answer concerns the length of the loan. The monthly cost for the ARM is calculated on the basis of a 30-year loan term while the fixed-rate mortgage must be paid off in half that time. There are fewer months to repay the fixed-rate loan product so the monthly costs must be higher.

Always consider your options. Sometimes a loan product with a lower rate can have a higher monthly cost, sometimes much higher. In this case the 15-year loan has a steeper monthly expense, however, after 15 years the cost for principal and interest will drop to zero while the borrower with 30-year mortgage will keep on paying. Which option is "better" depends on your finances and personal preferences.

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