Alternatives to the 30-Year Fixed Rate Mortgage
With 30-year mortgage rates hitting the highest level they've been in the last 20 years, a lot of people are looking for alternatives to that 30-year fixed-rate mortgage. There are three alternatives that we can look at; one option that is typically a bad option, one that is oftentimes a good option, and then there's a great option for us to consider. The three alternatives are:
Alternative Mortgage Options
Adjustable Rate Mortgage
The first option is an adjustable-rate mortgage which is also called an ARM. ARMs are fixed for a period of time and then they adjust after that. ARMs typically start with a lower interest rate than fixed-rate mortgages, so ARMs are a great option if you’re trying to get the lowest possible mortgage rate starting out. Common ARM lengths are five years, seven years, or ten years.
Rate Buydown Mortgage
The second option is a rate buydown mortgage. The rate buydown mortgage is still a 15-year or 30-year fixed product but it allows you to buy down the interest rate so that it's lower for the entire period of the loan, not just the adjustable rate period, but for the entire fixed amount of 15 years or 30 years.
2-1 Rate Buydown
The third option that you might consider right now is called a 2-1 rate buydown. It’s still a 15-year or 30-year product but the difference is you have a buydown for the first two years, 2% the first year and then 1% the second year. For example, if the interest rate is 7%, in your first year the interest rate will be 5% and in the second year it will be 6%.
30-Year Mortgage Rate Trends
Before any recommendations, let's look at the chart for the 30-year mortgage product for the last several decades. You'll see we've had a non-normalcy over the last 20 years where rates have been artificially low, we're now back at rates that we've historically seen over the last several decades which is 7% to 8%.
If you believe that we're returning to normalcy and we're going to continue to see 7% and 8% rates, your best option would be a rate buydown since rates would typically stay in that range for the next decade or two. You'd want to buy down that rate and keep that rate as low as possible since there would not be a refinance option under that scenario.
However, look at this next chart that focuses on the US total debt load. Since the US total debt load has ballooned over the last several years, we now have a situation in which I don't believe that our country can afford an interest rate level of 7% or even at a 6% level. That’s because the interest just amounts to too high a debt burden where we can't pay that.
So if you believe that, then you would not want to do an interest-rate buydown. Most people believe that the interest rates that we're seeing right now are not sustainable, which is why I'm not recommending rate buydowns for our clients right now. If you believe that the interest rates are not sustainable for the debt load that we have in this country, then you're going to probably want to look at one or two products.
One product that I'd recommend looking at right now is an ARM, an adjustable-rate mortgage. Since most people are predicting that rates come down in the next 1 to 2+ years, an adjustable-rate mortgage makes perfect sense. You have a five-year, seven-year, or even a ten-year product that can get you a much lower interest rate than your typical 30-year fixed-rate mortgage. It’s also something that I'm personally using on homes that I'm buying right now. So for most people, I think the adjustable rate mortgage is the best option.
There's another really good option that I think is good for a lot of specific buyers and also really good for marketing for sellers and builders, which is the 2-1 rate buydown. The 2-1 rate buydown is a fixed rate, but it buys down that rate 2% the first year and 1% the second year. For example, today's rate is 7% so your rate would be 5% in year one and then 6% in year two. What happens is you actually prepay that interest. It's good for the buyer if a seller pays because otherwise, you're just paying that pre-paid interest out of your pocket. You might as well just keep that in savings and pay that along the way.
If you can get the seller to pay it for you, then it can be an ideal situation, especially for buyers that know over the next two years rates are likely to drop and they can refinance when they do. It's also good for buyers that will have different life situations in a year or two where they will have more cash to pay towards their home.
We also recommend a 2-1 rate buydown to a lot of sellers and a lot of builders that are sellers. The reason for that is you can offer a teaser interest rate starting in the 5% range, since most buyers are payment buyers versus cash buyers, it allows you to broaden the horizon and have more buyers interested in your home.
Please note that everything in life has a risk and so all of these scenarios that I'm going through are calculated risks. You want to be able to make that calculated risk but also plan for the downside. What happens if rates don't go down in the next two years? Do you need to look at a three-year ARM, look at a five-year ARM, and maybe even a seven or ten-year ARM to mitigate your risk? Another thing to look at is how long are you going to be in that home. If you're not planning on being in the home for more than ten years, you don't need a 30-year mortgage. An adjustable-rate mortgage makes a lot of sense that way and it puts a lot of interest savings back into your pocket. So look at the downsides, what will that rate adjust up to, and do you have a plan in place if it does hit that extra interest rate?Posted by Matt Curtis on