Is 7/1 ARM mortgage a stupid idea with current rates?

[jamesbond007]

So a friend of mine is buying a house (happy for him), but he is opting for a 7/1 ARM @ 3.125 APR. 30 year fixed is costing him 3.875 APR. Is he making a mistake? Sure, who knows what happens in 7 years, but my feeling is 3.875% is low enough to lock in for 30 years and not worry about it. If the rates fall, refinance. If not, 3.875% is a solid rate historically. But the risk I see with a 7/1 ARM is if the rates go up to say even 4.5%, he ends up paying a lot more in interest. Also, he doesn't plan to payoff mortgage in 7 years.


Is he making a bad financial decision? Am I missing something? Which one would you pick?

[frugaliknowit]

If he's a standard buyer, yes, he is taking too much risk for too little reward.  There's too little upside and too much potential downside.

If he's an MD who just got out of medical school or a similar scenario (extremely likely to have a skyrocketing income), or if the mortgage is a VERY small percentage of his income, it might be ok.

Can you give us more information?

[jamesbond007]

He is a very standard buyer. I don't think there is a way for his income to go up to a level that would minimize the risk. Now, I don't know if he has a secret stash hidden somewhere. But, even if he did, that money could go to an investment.

[SimpleCycle]

I personally would get a 30 year fixed mortgage.  I also personally would not concern myself with someone else's mortgaging decisions unless I'd been asked for advice.

[jamesbond007]

I personally would get a 30 year fixed mortgage.  I also personally would not concern myself with someone else's mortgaging decisions unless I'd been asked for advice.

Just FYI, I consider this question as self education to make sure my thinking is in the right direction. Not sure what's wrong with that.

[Catbert]

How likely is he to keep this house for 10+ years?  If he'll probably sell before then, it may be better off going with the 7 year ARM.  If he'll likely keep for a loooong run then the fixed rate is a better bet.

I've bought a lot of (mostly rental) homes in the past 35 years.  Only once did I get an ARM.  I have a vacation home that had a mortgage of 4.75% (good rate at the time I bought it).  I refinanced to a 3.0% 7 year ARM.  I've set my payments such that it'll be paid off in 9 years (7 years at 3% and assuming 1 year at 4%, and 1 year at 5%). 

[SuperSecretName]

I think that most people only keep a mortgage for something like 7 years anyway.

I don't think it's that bad.  But, I would encourage him to invest the payment difference. 

You can think of a 30 year as buying interest rate insurance.  It's expensive.

[SwordGuy]

I think that most people only keep a mortgage for something like 7 years anyway.

Until they buy something with 5% down, on a payment plan that barely moves the principle over 30 years, and the market price goes lower so they can't afford to sell.   It isn't pretty at that point.

I would argue that 99+% of Americans have no business with a ARM at today's low fixed interest rates.

Most have little to no savings.  Live paycheck to paycheck.   Are way too much in debt for items that have lost most of their value.  Income is likely to be stagnant or even go down in bad economic times (no more overtime!)

And therefore, they cannot deal with a problem caused with a mortgage payment resetting with the interest rates going much higher.

The less your friend fits the above categories, the less bad an ARM would be for them.

 

[VaCPA]

Most people do the trade up thing a couple times so if this isn't his forever home he might come out ahead. But he should think hard about his longterm plans and if there's even a moderate chance he'll keep the house longterm to either live in or rent the 30 year is probably the best bet with how low rates are.

[TomTX]

If he's a standard buyer, yes, he is taking too much risk for too little reward.  There's too little upside and too much potential downside.

If he's an MD who just got out of medical school or a similar scenario (extremely likely to have a skyrocketing income), or if the mortgage is a VERY small percentage of his income, it might be ok.

Can you give us more information?

The "standard buyer" is selling that house by 7 years anyway.

[Dicey]

If he's a standard buyer, yes, he is taking too much risk for too little reward.  There's too little upside and too much potential downside.

If he's an MD who just got out of medical school or a similar scenario (extremely likely to have a skyrocketing income), or if the mortgage is a VERY small percentage of his income, it might be ok.

Can you give us more information?

The "standard buyer" is selling that house by 7 years anyway.

Yup.

[frugaliknowit]

Yes, the average homeowner doesn't keep a mortgage long...however just like you buy fire insurance and auto insurance a very ugly scenario could rear its ugly head:  Rates are heading way north, value of property isn't, owner's income drops or otherwise doesn't qualify for a refi, in short f'd!  If your friend is "financially thick/dense", maybe it's worth the risk, but for typical/average folk, I say "no way"!

[respond2u]

Is he making a bad financial decision? Am I missing something? Which one would you pick?

That's what, about $100/mn difference in loan rate? $1200/year?

If he knows he's going to move, it's good--it'll help counter realtor fees (6% of house price?).

If there's any chance he'll stay, I'd go with the 30 yr mortgage. 7.5 years from now, a 3.875% mortgage will look really good. And if $100/mn is enough to make a difference in buying the mortgage (he's not buying the house), then he can't really afford the house.

[jamesbond007]

Thanks for the input. Again, this is just for my learning. I am not giving him any advice as he has not asked me for one.