Don’t Over-React to the Mortgage Rate Rise

Over the past few months mortgage rates have begun to rise a bit. And the expectation is that they may continue to drift higher throughout 2017. While there’s no question mortgages now cost more, I want anyone thinking of buying a home, or refinancing, to not over-react to higher rates. Keep in mind:

A fixed rate mortgage is still an amazing deal. Yes, yes, I know that the interest rate on a 30-year fixed rate mortgage has risen from around 3.5% last summer to 4.1% recently. That definitely makes a mortgage more expensive. But I want you to understand that 4% or so is still an amazingly good deal. Between 1971 and 2009 the average interest rate on a 30-year mortgage never dipped below 5%. And here we are still well below 4.5%.

The lowest rates go to the highest FICO credit scores. According to FICO, someone applying for a mortgage with a credit score of at least 760 might qualify for a 30-year fixed rate mortgage charging 4% interest. If the same borrower has a FICO score between 700-760 the rate rises to 4.2%. And with a score between 680-700 the rate hits 4.4%. You can’t control what happens to interest rates, but you have total control over your credit score. Make it a priority to get your score up into the 760+ level before you buy a home.

Adjustable rate mortgages (ARM) are cheaper, but riskier. With mortgage rates beginning to rise, I won’t be surprised if there is more interest in ARMs. I advise extreme caution. The way an ARM works, the initial interest rate is set for a period. With a 1-year ARM, the rate is set in stone for just 1 year. With a 5/1 ARM the initial rate doesn’t change for the first five years. If you are shopping for a mortgage right now, the interest rate on a 5/1 ARM could be around 3.3% if you have a great FICO credit score. That’s indeed a lot lower than the 4% or so you might pay for a 30-year fixed rate loan. (“Fixed” means the interest rate never changes.)

I get that looks enticing. If you told me you were going to move in five or so years, I might tell you a 5/1 ARM could be smart. But if you plan on staying in a home for a long time, you must think about the “what if” scenarios after the initial period expires.

If rates are higher—and remember, right now they remain very very low-you will see your rate adjusted upward. Most ARMs can increase as much as two percentage points a year, and a maximum of 6 percentage points over the life of a loan. So let’s say that in year six of your 5/1 ARM rates are much higher. You could see your mortgage rate jump from 3.3% to 5.3%. If rates kept on rising, the next year (year 7) the adjustment could send your interest rate to 7.3%.

Meanwhile, if you opted for the 30-year fixed you would still be paying a mortgage with a 4% interest rate. There are plenty of online calculators that will help you game out the potential rising cost of an ARM.