Adjustable Rate Mortgages for Short Term Home Purchases
Oct 16, 2020 | 12:00 am
In a recent session with Hopkins residents we discussed the rule of thumb that it doesn't make sense to buy a home unless you plan to be in the area for at least 4 years. We also discussed the differences between fixed rate and adjustable rate mortgages (ARMs).
Connecting both topics the following question was asked: "what if you plan to finish residency/sell your home before the ARM will adjust?
ARMs come in various formats, with a variety of teaser rate periods ranging from six months to ten years. Rates are initially fixed at low values and therafter periodically reset based on an underlying interest rate index[1]. A variable rate loan (ARM) exposes you to interest rate risk -- that is, the risk that rates will rise, saddling you with (potentially much) higher monthly payments after the low teaser rate ends. A fixed rate loan doesn't expose you to such risk because the rate is known and locked-in; it doesn't change.
Currently, rates are near historic lows. To me that makes the fixed rate loan a no-brainer. We get to lock-in very low rates by historical standards, and we avoid interest rate risk exposure.
ARMs are often pitched as useful tools if you plan to refinance your home loan or intend to sell the home before the ARM's low teaser rate expires.
Let's review the 4 year rule of thumb for home onwership. Why does it exist, and why is it 4 as opposed to 3 or 5 years?
When you purchase or sell real estate you are responsible for covering closing costs: legal fees, appraisal fees, inspection fees, mortgage loan issuance fees, etc. These fees typically range from 2 to 5% of the sale price. If you are the seller you also must cover the real estate agent fees, which tend to be around 5 to 6% of the home's sale price. As a buyer, you avoid "throwing money away" on rent payments, and instead pay a mortgage that helps to build equity in the property. On average, it takes about 4 years for a buyer to gain enough homeownership benefits (from a money-saving perspective) to offset the closing costs. The higher the closing costs relative to the home price, the longer you need to be in that home to overcome the upfront costs and end up ahead.
We now know enough to answer the original question: "what if you plan to finish residency/sell your home before the ARM will adjust?"
If you plan to buy and sell the home within your residency period, you'll be paying closing costs twice within, say, two to three years.
Mathematically the answer comes down to:
(A) how much interest you save by going with the lower teaser rate for two or three years instead of the higher fixed rate mortgage
(B) the increase in the value of the home while you own it
versus
(C) the combined closing costs you must pay to purchase and then sell the home
You can estimate (A) and (C) in advance, but you have no guarantees for (B). In fact, the home may decline in value.
But there's more. Suppose you plan to leave that location and sell the home before the teaser rate expires, but circumstances change. You suddenly realize it makes more sense to stay in that area. This could be because you find a good job nearby or you decide it's important to allow your children to remain close to their friends. You could try to refinance the loan with a fixed rate mortgage, but you'll then have to pay refinancing costs, and you may end up with a higher fixed rate than you could have obtained years earlier, especially if rates increased over those few years. In other words, the interest rate risk is realized. It's possible this could work out favorably for you, but it's difficult to predict. Another complication would be finding it difficult to sell the home. Inability to sell the home within your desired time frame and at a decent price would add more anxiety for you and your family and make it difficult to start your new life in a new location on the most favorable terms. Is this a distraction you're willing to live with?
In summary, my strong inclination would be to only purchase a home if I have good reason to believe I will be in the area for at least four years, and since rates are now near historic lows, I would opt for a fixed rate mortgage. Otherwise, I would rent and save as much money as I could for a downpayment.
There are other considerations as well. You can purchase a home during residency and instead of selling it after four years you can rent it as an investment. This is easier to pull off if you end up living nearby, allowing you to make repairs or oversee maintenance personally, interview prospective tenants, etc. If you live far away it's harder to manage a rental property. You can probably find a real estate company to help you manage these functions. Usually they'll charge you the equivalent of one month of rent per year for such a service. Since it's hard to predict where you'll take your full time job after residency, it may not be adviable to purchase a home under the assumption you'll be able to rent it easily.
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[1] Consumer rates correspond to the underlying index value plus some added margin or spread.