Do you know what it was like to buy a house in 1982?
You pulled up your Trans Am to the bank where the picture of President Regan hung on the lobby wall and got your checkbook out of your jean jacket. Then you signed up for a 30-year mortgage with a 17% interest rate!
The housing market, along with the rest of the world, has changed quite a bit since then. Now, you sit at home in your pajamas and compare interest rates across several lenders on high-speed internet – rates that are usually less than half of what you paid a generation ago.
COVID-19 tipped the gravity once again with this discussion and left us with historically low mortgage rates. The virus, quarantine and consequent economic depression caused the Federal Reserve to tank interest rates, leaving mortgage rates around or below 3.5% for most of the year. Compare this to a consistent rate of over 4% for several years running.
We’ve come a long way since mom and dad’s Trans Am scenario, which means a culture shift for housing finance and the need for new strategies, especially in an off-kilter year like 2020. Let’s look at some new cautions and opportunities in the housing markets.
Variable-Rate Mortgage versus 30-year Fixed Mortgage
Introduced in the 1980s, variable-rate mortgages – also called adjustable-rate mortgages – were a step toward helping the average American own a home. The variable rate could come in much lower than the going interest rate, which might make it more appealing to Joe and Jane Public as they scraped their pennies together.
Unlike generations before, who had to procure tens of thousands in cash and look down the barrel of a very high monthly payment for decades, the variable-rate put homeownership in reach. Joe and Jane could start homeownership with an interest rate at sometimes half of the 30-year fixed rates, which were nearly out of reach for most people in the middle of the bell curve in those days.
Today, the variable rate can be especially helpful if your life is set to change regularly. If you plan to move in five years, it can be advantageous to lock in that low interest rate for that limited initial period. You’ll also have a lower initial payment.
The risk with variable rates is that they – guess what? – vary.
Twenty years ago you may have been able to get a variable-rate mortgage at 3%, beating the market standard of 8%. This adjustable-rate was good for five years, and then you hit the going rate of 6.5%. It might stay there for a year before changing again – and change could mean going up! On the other hand, your rates could go down for certain periods over the life of your loan, depending on the markets.
If you were able to get a 30-year fixed-rate mortgage at 4%, then it would still be the same rate, no matter if the markets went up or down. Initially, you would have paid a bit more, but you don’t have to worry when the markets go up a few years later. Conversely, you don’t get to party when they go down, because your rate is locked in.
The debate between variable versus fixed-rate mortgages is a standard in financial circles, and both have pros and cons depending on your financial journey and goals. However, the current markets brought in a wild card because of the Fed’s efforts to shore up the economy.
With the lower federal rate, mortgages in early August are coming in at 3%. A popular variable-rate mortgage, the 5/1, is coming in at 2.5%.
Do the Math
Let’s look at the math. Yes, 3% is higher than 2.5% by half a percent. At the 2.5% rate, you would save $5,000 over five years on a $200,000 home loan. But after that, you’re subject to whatever interest rate benchmark your variable-rate loan is tied to.
Five years from now, interest rates could spike. If the interest rate on your loan suddenly jumps to 6% for a year, that $5,000 you saved is going to disappear quickly.
Sticking with a 30-year fixed-rate, especially one you obtained in a low-interest market, will save you a lot in the long-run. Expand your vision from a few extra digits on the monthly bill to those few extra digits added up over the years.
The variable-rate deal, which a bank or realtor might put in front of you, is similar to the maneuver often made by cell phone services. You sign on for a deal that shouts in loud, large-font letters: “PHONE FOR $29!!!” You don’t look closely enough to see that next to all those flashy words it says “per month.”
Well, you can cover 30 bucks a month, no problem. But after two years, you find you’ve paid $720 – plus a small horde of hidden fees – for the phone. That’s not unreasonable, but it’s not peanuts either, and it certainly feels different than the easy $29 you were promised on that first day. This is a small scale example of what could happen with a variable-rate mortgage, it looks smaller now, but you have to consider the life of the payment plan, not one installment.
Play 4D Chess
The slang term “4D chess” comes to mind when we think of variable versus fixed mortgage rates – which means you think and move in four dimensions, seeing beyond what’s right in front of you. We have to play 4D chess in an economic environment like 2020. We’re seeing counter-intuitive circumstances, like traditional and variable-rate mortgages at nearly the same rates, and it isn’t over yet.
In complex times like this, a meeting with your advisor can help you simplify and clarify. How can we help you? Get in touch today and we’ll help you plan out your next move.