Recently I had a home under contract and the buyers were all set to use a 30 year fixed rate FHA loan until I suggested they look at an adjustable rate FHA mortgage. So which is better – fixed or adjustable? Of course, the answer depends on your personal situation. Before we get into comparing the FHA fixed vs the adjustable, first let’s determine if you should even be using a FHA loan.
FHA VS CONVENTIONAL
FHA loans are best for buyers with a limited down payment or buyers who need to stretch their ratios a bit. For most buyers with 5% down and almost all buyers with 10% or more down, conventional loans are better. Why? Mortgage insurance. One of the recent changes to FHA loan guidelines is that the FHA mortgage insurance will be paid by low down payment borrowers for the life of the loan. Repeat – the life of the loan. Conventional mortgage insurance will be dropped when the loan to value is 78%. This results in a significant reduction in your monthly payment.
Two main reasons buyers use FHA
Purchasers with limited funds. FHA allows for a down payment as low as 3.5%. Plus the entire down payment and all closing costs can be funded by a gift from a blood relative. Such gifts are not allowed in conventional loans unless the down payment is substantial.
Purchasers who need to stretch ratios. Under recent changes, conventional loans, with very few exceptions must keep debt ratios at 43% or below. (Mortgage plus other monthly debt payments must be below 43% of the monthly gross income.) FHA allows ratios in the mid 40s and sometimes, with good credit and compensating factors in the high 40s. It sounds dangerous to “stretch” ratios even if the lender allows it as, on the surface, it seems like a quick path to financial suicide. That can be the case but are many reasons why stretching ratios is not a risk. Here are 2 common situations where it makes sense to stretch.
Two situations where stretching ratios makes sense
Example 1. A couple plans to buy a home together. Using both incomes, the ratios are in the low 30s but one spouse has bad credit and the lender will not allow that person on the loan. So doing it on one income means ratios – on paper – of 47%. A conventional loan would not work. A FHA loan will. The reality is that the household income is much higher than the lender can use and this couple is not in trouble.
Example 2. A buyer is in a salary plus commission job where significant commissions are almost guaranteed. Using total compensation, the ratios are in the low 30s but since the person has been in the job only one year, the lender can only use salary to qualify. Lenders need a 2 year history of commission or bonuses to count them for qualifying purposes. So using salary only, the ratios are 47%. Again, not a household at risk.
So, for buyers needing an FHA the next step is deciding fixed vs adjustable.
FHA FIXED OR FHA ADJUSTABLE?
The FHA adjustable loan is actually a relatively safe product. The start rate is fixed for 5 years and each year after that it can adjust up or down 1 point. Over the life of the loan, if can only adjust 5 points above or below the start rate. So, in the worst case scenario, it would be year 10 before the highest rate is possible. Remember, the rate increases are tied to an index like treasury yields. Unless these indexes move up rapidly, it is unlikely you will max out the rate in 10 years. For instance if you had used an FHA ARM for a purchase in 2005, your first adjustment period in 2010 would likely have been a downward adjustment. And while you could have had increasing rates over the last few years, you would be very close to where you were in 2010. Nine years later, your rate would still be at or below the start rate. No one knows the future. Should rates jump to 10% over the next few years, then yes, you will slowly climb to the max. If they increase only to 5%, you will climb to that range and stay there.
But always best to plan for the worst. Let’s compare the cost of a $300,000 mortgage using a fixed rate and an adjustable. I will use 4.5% for the fixed rate and 4% for the adjustable start rate. Those numbers are slightly higher the rates as I write this but for purposes of this example the actual rates don’t really matter. The adjustable will usually be about 1/2% below the fixed so the amount of the payment will differ but the savings will flow about the same. Note, the payment numbers do not include taxes, insurance, mortgage insurance or condo or HOA fees. These numbers are the same regardless of the mortgage product selected.
|ADJ VS||ADJ VS|
|FIXED||FIXED||ADJ||ADJ||+/- PER||+/- PER||TOTAL|
So this chart shows that for 7 years you save money with the adjustable but it starts to go south fast in year 8. However, remember that the increases may not be that fast. Say in year 6 it goes to 5% but then stabilizes so in year 7 there is no increase. Then you stay ahead through year 8 and the max cannot be reached until year 11.
OKAY, SO WHICH OPTION IS BETTER?
Selecting a mortgage product involves lots of guessing about your future. First big guess is how long will you own the home? If the answer is 7 years or less, the adjustable is the clear answer.
If you think you will own the home for more than 7 years, you need to make a few more projections. Remember the mortgage insurance stays with an FHA loan for the life of the loan. On a $300,000 loan that runs about $325 per month. It is in your best interest to refinance out of the FHA loan to get rid of the mortgage insurance as soon as possible. Do you think your home will appreciate so your loan to value will be below 80%? At that point you can refi into a conventional and get rid of the mortgage insurance. Do you have some sizable amount of money coming to you in the next few years which would allow a refinance to get the loan to value below 80%? How high do you think rates will go up in the next few years? Using a mortgage calculator you can see that if you took out a $300,000 loan at 6% with no mortgage insurance you would have a lower total payment than a 4.5% FHA loan with mortgage insurance. And last, we don’t know what innovative mortgage products might surface over the next few years that would allow you to refinance out of the FHA loan.
Now, if rates increase to 7% or more over the next few years and home values remain stagnant, then the fixed is a much better long term choice as a refinance in those conditions would make no sense.
So, it is a gamble either way. I think so many things in the economy and in the housing market need to go wrong quickly and stay that way for a fixed to be the better choice. I would like to think that would not be the case. I tend to be optimistic that for the most part things will stay positive and that downturns will be brief. In terms of housing, no doubt the 2008-2011 period was devastating for many families but it was a short period of time when thinking that a home is usually held for 7 years or more. With small adjustments over 5 year period, an FHA adjustable avoids some of the market volatility.
So you need to decide which is best based on your perception of future interest rates and future housing prices coupled with your best guess as to how long you will own the home.
What about the buyers who initiated this conversation? They realized that in 7 years, their kids would be out of school and they would then want to leave the area so they opted for the ARM.
Last point and disclaimer. I am a Realtor. I am a Realtor with a pretty good understanding of financing but I am not a lender. So work with your lender to determine the best loan for your situation. There may be nuances in each loan product that I am not aware of that make one better or worse for you.
Image courtesy of Stuart Miles / FreeDigitalPhotos.net”.