Advice from Nashville's Financial Guru Dave Ramsey

Dave Says
By Dave Ramsey
Author of Financial Peace and The Total Money Makeover
9/20/2004

Adjustable rate vs. fixed rate - which is better? 

Dear Dave,

Would you please explain the difference between an adjustable rate and a fixed rate mortgage? Which do you think is better? 

Janet
Nashville, Tenn.
 

Dear Janet, 

An adjustable rate mortgage is something you never do and a fixed rate is the only one worth considering. 

A fixed rate mortgage is pretty simple to explain. The rate of interest is fixed and it never changes. It's that simple. The rate stays the same as long as you keep that mortgage. It could only change if you got a different mortgage through refinancing, selling the home or something like that. 
The adjustable rate loans are horrible loans. They are a bad product. They were introduced during the early 1980s. I was a young guy selling real estate in those days and interest rates went from 10% in 1978 to 17% in 1981. Needless to say, the real estate market was paralyzed. Banks and Savings & Loans discovered that they had a bunch of 6% and 7% loans from the 1970s on the books. They were paying out on money market accounts in the 12% to 13% range. So, in other words, they were paying high rates of returns on things like money market accounts and certificates of deposit, but collecting low interest rates on those old home mortgages. This is the reverse of how they like to operate. They determined not to be left in that position again, so they invented the adjustable rate mortgage, or ARM, where the risks of higher interest mortgage rates were passed on to the consumer.

 
We were told in the real estate business that the adjustable rate mortgage was a way to get a cheaper interest rate, which is true, but the borrower takes a large amount of risk for it. Adjustable rate mortgages take a lot of forms, but usually they are one- or three-year ARMs. This means the interest rate adjusts once a year or once every three years. The typical Fannie Mae ARM has a 2% annual cap and a 5% or 6% lifetime cap; meaning that from the time you borrow the money the interest rate can go no higher than a certain amount. 

The rate is adjusted based on an index. For instance, if the index you're using is the T-Bill Index, then your mortgage interest rate will reflect what T-Bills are doing. For example, if it comes time for your mortgage to be adjusted and T-Bills have gone up 1.5%, your mortgage will go up 1.5%. So it's gauged based on what that particular index does. The T-Bill index is the typical index used in most ARMs, but there are also the Funds Index and the Libor - which is a London index - among others. 
Basically, they all adjust and they tend to adjust upwards because they tend to start you in the hole. So, I would never take an adjustable rate loan. Especially in a low interest rate environment such as we're in now. Where are rates apt to go when we have the lowest interest rates we've had in 30-40 years? On average, they're going to go up. I'm not making a prediction, but I'm saying it's a safe assumption. Think about this. Never take an ARM.
Dave

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