Spread Widens between 30 Year Fixed & 5 Year ARM

(February 28th, 2008)

The spread between the 30 year fixed mortgage & the 5 year Adjustable Rate mortgage continues to widen in this commodities bull market where the price of oil, gold, grains & basic materials continues to go through the roof. In Bankrate.com's rate survey for the week of Monday February 25th, 2008 the 5/1 hybrid ARM stood at 5.77% while the rate for 30 year fixed mortgages stood at 6.37%. At the beginning of 2008, both mortgage products stood at roughly 6.14%. This means the 5/1 hybrid ARM is becoming cheaper for investors to borrow and with which to finance their homes.

At the beginning of 2008, it made no sense to borrow a 5/1 hybrid ARM when the 30 year fixed was available at identical interest rate of 6.14%. Since then the 30 year fixed has gone up 23 basis points while the rate on the 5/1 hybrid ARM has fallen 37 basis points. What's more interesting to find is that the 30 year fixed has spiked up even higher since the last Bankrate.com survey, probably at around 6.50% right now. This means it has risen another 13 basis points. The gap between the two mortgage products could now be a significant 3 quarters of a percentage point.

Does this mean you should purchase the 5/1 hybrid ARM mortgage instead of the 30 year fixed because it is cheaper? Well the answer once again is, "it depends." If you are looking to get in to the housing market for the short term (maybe 3-5 years), then yes a 5/1 hybrid ARM makes sense. However, you must get out of the house within the next 5 years because I expect mortgage rates to go higher in that time period. This is because we will pay later for the Fed's loose monetary policy and rate cutting campaigns today.

In this article, we will differentiate between choosing a 30 year fixed mortgage and a 5 year adjustable rate mortgage. Which one of the two is better? The answer is, it depends on how much of a home you can afford. There is no right definitive answer as to which is better. The consumer has to look at his financial need and his short/long term financial goals.

Some people don't like change. These are the conservative people who value long term financial security and a 30 year fixed term mortgage provides just that; a mortgage rate & payment structure that will not change with market conditions. Instead of worry about how much they will pay in interest this month, these people will be able to sleep every night peacefully.
The major disadvantage of 30 year fixed term mortgages to lenders is the increased amount of long term risk and the time value of money. The banks will figure they are tying up their money in a fixed interest rate investment for a 30 whole years; who knows whether the borrower will even be able to repay that loan back? And what if mortgage rates move higher in those 30 years; the bank will lose money due to opportunity cost!

This is why it is more expensive to borrow a 30 year fixed mortgage than a 5 year ARM. Lenders want to be compensated for the increased risk of lending a 30 year loan, that is why the interest rate difference between the two is usually 1-2%+. Between the 30 year fixed and 5 year ARM, which one should consumers therefore choose? Borrowers should look at the timeline of their lives for the next 5 - 15 years. How long will they want to occupy the house? For example if you expect to call the moving trucks in another 7 years, there is no reason why you should opt for the 30 year fixed term mortgage and pay a higher interest rate for it.

If you select an Adjustable Rate Mortgage (ARM), the lender will lock your rate for 6 months - 2 years. After that, your interest rate will fluctuate with current market rates. This way, the bank does not tie you in for a 30 year fixed rate, thereby reducing their risks of opportunity cost + time value of money. This usually means a reduction in interest rates for you.

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