Fixed-Rate vs Adjustable Rate vs Balloon Mortgages

November 11, 2001

"My broker has offered me the following 6% loans: a 30-year fixed-rate at 1.125 points; a 7/1 ARM at 1 point; a 7-year balloon at 0.375 points; a 5/1 ARM at .875 points; and a 5-year balloon at 0 points. How do I decide which mortgage is best for me?"

You have made a good first step. By standardizing the interest rate at 6%, the price differences are entirely in the points. (One point is 1% of the loan amount). These price differences are related to risk differences between these options. The question is, which combination of price and risk is best for you?

The broker left out the 15-year fixed-rate mortgage (FRM), perhaps because you can’t afford the payment. The payment on all the others is based on a repayment period of 30 years. On the day you were quoted the rates above, a 6% 15-year loan carried a rebate of 1 point – that’s 2.125 points less than the 30-year fixed. From a price and risk standpoint, the 15-year is the most attractive of the options, but the borrower must be able to handle the payment.

The 30-year FRM generally has the highest price because it carries the most risk for the lender. If interest rates rise significantly, the lender is stuck with a relatively low rate for what could be a very long period. For the same reason, this loan carries the least risk to the borrower.

What is striking about the prices quoted to you, however, is how little it would cost you to obtain this protection. Compared to an adjustable rate mortgage (ARM) on which the initial rate holds for 7 years, you must pay only .125 points more for the 30-year FRM. At that price, you should select the 30-year FRM if there is any chance that you might still be in your house after 7 years.

However, the price of protection quoted by your broker is too low to be representative. When I shopped 30-year FRMs and 7-year ARMs offered by the same lenders, I found price differences ranging from .7 to 1.4 points when the rate was the same. Your mortgage broker mixed and matched from different lenders, which sometimes reveals strange bargains.

At the higher price differences that I found, selecting the 30-year FRM is no longer a slam-dunk. It depends on how likely it is that you will still be in the house after 5-7 years, and how much risk you are willing to take.

Assuming you decide against the 30-year FRM, the choice between an ARM and a balloon hinges on the same factors. The balloon is priced lower because it has less risk to the lender, and therefore more risk to you, than the ARM.

At the end of the 5 or 7 years, the balance on a balloon loan must be repaid. If market rates increase markedly over the period, the lender will be able to reinvest at the market rate, and the borrower will have to refinance at the market rate.

The borrower with an ARM, in contrast, has some protection against an interest rate explosion. Virtually all ARMs contain maximum lifetime rates, caps on the size of any rate change, or both. The new ARM rate, therefore, will probably be below the market.

Between 1976 and 1981, for example, mortgage rates increased by about 9%. A borrower with a 5-year balloon that came due in 1981 had to pay about 9% more for another balloon. In contrast, a borrower with a 5-year ARM that had a 2% adjustment cap and a maximum rate 6% above the initial rate, paid 2% more in each of the years 1981, 1982, and 1983.

A rate explosion within the next 7 years is unlikely but possible. The question is whether the protection provided by an ARM is worth the added cost of .625 points on the 7-year, and .875 points on the 5-year? Only you can answer that.

If you elect the balloon to save money, the 5 versus 7 is a close call. With a price difference of .375, you could go either way.

If you elect the ARM, the price difference of only .125 points between the 5 and the 7 appears very low for two years of extra protection. However, ARMs may differ in other important ways, including rate caps, that need to be considered. 

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