We received our weekly interest rate update on Monday and mortgage rates have managed to slide back down to pre-election levels. The curve is fairly steep right now when looking at the pricing of the various mortgage products. It got us thinking that this is a good time to stay away from the one-size-fits-all method. With 140 basis points separating products, there are real savings to be had if you have a pretty good sense of your time horizon.
Time horizons are difficult to project because there are so many external factors which influence personal and professional decisions during a period of time. That said, if you look at normal distributions there is a pretty good chance that your lifecycle will fall within a one or two standard deviations of the norm. Let’s look at an example: A 25-year-old professional living in Manhattan in a studio apartment will most likely see significant life changes in a ten year period. If for no other reason, that individual will most likely upgrade to a one or two bedroom apartment because they have that much more “stuff” to deal with.
That same individual had choices when purchasing the studio. Do I fund it fixed or floating and if floating, what type of ARM? Let’s say that the young professional’s time horizon (at the outside) is ten years but more likely seven years, then they should finance the studio with an ARM as opposed to a 30-year fixed rate loan because of the interest rate savings.
In today’s market, the savings versus a 30-year loan would be:
- 5/1 ARM – 100 basis points
- 7/1 ARM – 140 basis points
- 10/1 ARM – 65 basis points
Clearly, if the young professional has a pretty good handle on their time horizon, this market offers significant savings. At 2.42% for a 7/1 ARM, the property owner is saving about 37% versus the fixed rate loan of 3.80%. The calculus changes if the owner has no sense of timing or believes they will hold onto the property for investment purposes. Locking in 30-year funding, below 4%, will never be viewed as a reckless economic decision and will most likely pay handsome dividends during the life of the loan.