Should you do an adjustable rate mortgage?

A question came up with our mortgage broker as to whether we want to do 30-year fixed or a 5/5 ARM or a 10/1 ARM. When I looked at the numbers for the adjustable-rate mortgages, I didn’t really understand what they meant. All I remembered was people freaking out circa 2007 as their teaser rates adjusted upwards and caused them to default. I didn’t want any part of that.

But ARMs aren’t teaser rates. They’re more like a shared-risk loan. 30 years is a long time for a bank to lend money. It’s hard to picture it as the borrower, so try as an investor. If you buy a bond that locks your money away for a year, you might take 2%-4% interest, depending on the risk. But if the same bond matured in 30 years, you’d demand a higher rate. A lot can happen in 30 years (like the 1970’s with 12% interest rates).

On the other hand, if the bond paid based on interest rates now and adjusted upwards (or downwards) based on future conditions, you’d probably tolerate 2%-4% again. If inflation took off, your interest rate would follow. The same is true of an ARM. By buying 30-year rates, you’re locking in the bank. The bank assumes the risk of future inflation. If you think well, screw the bank, don’t imagine that they’re doing it for free. They’re charging almost a full percent over a 5-year ARM to take the 30-year risk.

What will interest rates do? This is a frustrating question because no one knows what the future holds. I have a psychological preference for an ARM because a 30-year fixed rate seems like insurance. And insurance pays out only enough so that the insurance company makes money. I have to believe the same is true of banks. If interest rates do go up, it will be because of higher inflation. Higher inflation means more money for me with which to pay back my loan.

Now, I haven’t stuck it to the bank if there’s lots of inflation. But banks are more in control of the monetary infrastructure of the United States than I am. So I have to believe that, all things being equal, interest rates will follow what they want more than what I want.