How do I compare a fixed rate mortgage and an ARM?

Suppose I have two mortgages that has the same amount of loan and maturity. One is fixed rate. One is fixed for the first n years and then after that it becomes LIBOR+x rate. Then how do I compare the two mortgages? I suppose this has something to do with interest rate model and swaps. Does anyone know any good intro books on this topic? Thanks

If this is a personal decision, then there are a few ways to approach it. With an IR model you can project randomized scenarios and do a monte carlo analysis of possible payment streams (for the ARM that is). Compare the mean PV to the fixed rate mortgage. But there’s the prepayment issue, which I think often dominates this choice. At one point the average mortgage was prepayed after ~7 years. Obviously only you can handicap this estimate, and it will make a big difference in the valuation results. If you think you won’t be in the property more than say 5 years, there’s no need to take a mortgage that locks longer than 5 years. (Assuming rates increase with lock tenor, as they typically do.) Also you may have a view on rates. Say ARM rates are as follows: lock rate ----- ----- 3y 3.0% 5y 5.2% 7y 6.5% 30y 6.8% If you think you’ll be a lifer in this property, you might go for the FR mortgage – especially if you think interest rates are mean reverting and long-term rates will float back up to something approaching their historical means. If you’re not sure how long you’ll stay, you might find the 5y rate’s advantage over the 7y to be worth going 5y. (Ask what the indexed rate were of your loan if it adjusted today. Typically it’s several percent above today’s lock rate – leading you to assume that at end of the lock period your rate will rise.) Also understand that refi’ing is pretty cheap, so even if you go with a long lock period and rates drop you can typically save by refi’ing.

Agree with DarienHacker - valuation with interest rate models,etc is useless because what really matters is how long you plan to hold the mortgage and what income path you are following. If your income is going up by 15% per year and are single and mobile that would matter way more than some swap rate.

Take the net present value of what you will save with the adjustable rate mortgage over the fixed rate mortgage (during the intro teaser term before it resets). Call that number the value of the option of being able to borrow at whatever the fixed rate is for the following 25-28 years. Compare it to the price of listed option on iShare long bonds.

This is easy: Compare the payment you would make on the 30-year fixed mortgage versus the maximum you would pay on the ARM. Almost always the cap on the ARM will be higher. Then, you need to ask yourself, “Can I afford the maximum payment if the ARM hits its cap on Day One?” If the answer is yes, get the ARM. If the answer is no, get the fixed-rate mortgage. Not asking this question is the reason why we are having a real estate/mortgage meltdown in this country: childish consumers buy homes on ARMS and assume their payment will be the low, introductory rate, even though ARM stands for ADJUSTABLE Rate Mortgage. People didn’t care, thought things would just work out and then reality comes crashing down around their ears. In my opinion, debt ratios on ARM’s should be based on the maximum rate/payment versus what the client currently makes, and that is how the consumer should consider how much house they will buy if going with an ARM.

The correct answer is that you should get a 5/1, as most people in their 20s and 30s move every 5 to 6 years, especially if they have increasing income streams. I suggest ING direct for ease of use and good rates on 5/1s.

^^No, that is a terrible idea. That’s what created the whole housing/credit mess in the first place. And, given the weak economy and bleak future prospects (Hilary and Barack are Socialists, and McCain is an economic idiot- all sure signs we are screwed, economically), it is folly to assume one’s income will increase significantly in the next 5 years. Rather, one should budget for a house payment based on their CURRENT income, since they know how much they are getting paid now. Nobody knows how much they will make 5 years from now.

c_hayhurst Wrote: ------------------------------------------------------- > ^^No, that is a terrible idea. That’s what > created the whole housing/credit mess in the first > place. Sorry, no points. There haven’t been unusual problems with borrowers who qualify based on current income and locked 5y ARM payments. The main problems have been: + underwriting based on 1- or 2-year “teaser” rates, where these rates are several percentage points below what even a 1-year ARM would price at. (I believe the agencies recently announced they would require underwriting at market rates from now on.) + unprecedented relaxation of subprime underwriting standards – in many instances this has been outright fraud. This occurred in 2005 and 2006; standards recovered in 2007 and loans originated last year are performing largely in line with historical default likelihoods.

Good thing we have c_hayhurst telling people what their risk tolerance ought to be. Of course, if you are on an escalating income path (and someone who is 25 is likely to be increasing their real earnings significantly even in a huge economic downturn) the low-risk path has you spending about 7% of the value of your previous house each time you move.