When Does a Variable Rate Mortgage Make Sense?

When you expect interest rates to drop in the next five years, because you borrowed a time machine and checked.

When you are house shopping, you often look at the price of the monthly payments faster than the cost of the house. After all, it is hard to wrap your head around paying tens or hundreds of thousands of dollars, even over the course of many years. Chances are you won’t even live in the house that long. So the monthly payments are a much more applicable number.

Yet this is a way of decreasing your monthly payments that leads you down a dangerous path. A variable rate mortgage may decrease your payments in the short term, but will shoot them to the stars
should rates go up. This is of particular concern in an environment where rates are at record lows.

Many adjustable rate mortgages come with a balloon payment at the end. For example, you get an adjustable rate for five years. Then they will insist that you pay of the loan at that point, basically forcing you to get another mortgage. Heaven help you if you have lost your job, missed some student loan payments, or run up your credit cards in the meantime.

Others loan options will fix the rate after five years, usually bench marking it to a market interest rate. These are somewhat better, but still expose you to increases in the market interest rate. The average mortgage at the end of 2012 costs 3-5%, depending on your amount of equity, particularly if you have more or less than 20%. It is unlikely that they will go down at all in the near future.

So what if you are considering a 5/1 mortgage because you don’t intend to be in the house more than five years? You probably shouldn’t be buying in the first place. A house needs to appreciate about 10% to pay for the closing costs of selling it. Gone are the days when that sort of appreciation could happen quickly; in fact you might lose value due forces beyond your control, such as a slump in the economy or the building of a large community sports complex in your back yard. So if you’re going to be moving, keep putting away money toward your down payment into medium-term investments such as bonds. Avoid stocks, you could get caught in a market downswing and lose money.

If you are going to be in one spot for a while, part of buying a house is protecting yourself from future rent increases. The rental cost on a house usually increases every year. Most renters wouldn’t balk at an increase of $50 per month. At the end of a decade, however, you’re paying $6,000 more per year than when you started. If you had bought the house 10 years ago, you would be saving those thousands in just that year alone.

Sticking to a budget is very difficult when home buying, especially if you live in an expensive area. But a variable rate mortgage these days is rarely worth the risk. Tighten your belt and live with slightly higher payments for now. You’ll save a ton in the long run.

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