Houses Are Expensive. Can Your Choice of Mortgage Help?

Even though most homeowners don’t keep their home for 30 years, the 30-year fixed-rate mortgage has dominated the U.S. home loan market for more than half a century. It’s the mortgage of choice for nearly 90% of buyers because it insulates them from inflation and changing interest rates, creating a relatively affordable monthly payment they can count on year in and year out.

But with real estate prices so high and mortgage rates stuck well above pandemic lows, should you look at other options? Here’s what to consider.

30-Year Mortgage Rates Have More Than Doubled Since COVID-19

Most homebuyers these days are stomaching 30-year fixed mortgages with an average interest rate in the high 6% range. While that’s not terrible by historic standards — they were higher for almost all of the 1990s and not all that much lower in the 2000s — the pandemic era set new expectations.

COVID-19 kept 30-year rates down around 3% for much of 2020 and 2021, and made even the 3.5%-4.5% range commonly seen in the 2010s feel expensive. The average dipped to a record low of 2.65% in early 2021, fueling a buying frenzy.

A few percentage points may not sound all that meaningful, but they make a huge difference. Let’s say you buy a home for $450,000, putting 20% down at closing. With a 30-year fixed rate of 6.93% (this week’s average, according to Freddie Mac), your principal and interest payment is $2,378 a month. With a 30-year fixed rate of 2.65%, it’s $1,450, about $900 less.

The comparative math gets even worse when you factor in property values, which have continued to rise, albeit more slowly, after jumping more than 40% in the first two years of the pandemic, according to the S&P CoreLogic Case-Shiller U.S. National Home Price Index.

In short, low rates helped counteract surging house prices before, but now that rates have more than doubled, that major silver lining is gone. So, could you lower your monthly payment with another type of mortgage? Possibly, but there are risks.

Adjustable-Rate Mortgages Are Cheaper, But Riskier

The beauty of signing up for a fixed rate for 30 years is the consistency and security. But if you’re willing to chance that your payments will go up down the road, adjustable-rate mortgages, or ARMs, can be a cheaper alternative.

Rates on ARMs are usually lower than prevailing rates on 30-year mortgages for an initial set period — typically three, five, seven or 10 years — but then adjust based on market conditions. When rates are high or prices are rising rapidly (like they were during the housing bubble of the early 2000s,) ARMs can be especially appealing for first-time homebuyers who expect to move fairly quickly.

That said, some ARMs haven’t been as good a deal recently. The introductory rate on a 5/1 ARM, for instance, has only been about a half a percentage point lower than the rate on a 30-year fixed, according to Bankrate. In the past, the discount has been 1 percentage point or more.

A Shorter Fixed-Rate Loan Will Raise Your Payment, But Save You a Lot

Fixed-rate mortgages with terms of less than 30 years have higher monthly payments than 30-year mortgages, so they can’t help you afford to buy.

However, buyers who can manage it should seriously consider a shorter term, and here’s why. When your rate is higher, you pay a lot more interest over the life of the loan. One way to reduce that burden is to borrow for less time. Plus, prevailing rates on shorter-term loans are typically lower than for 30-year loans.

Let’s assume you bought that same $450,000 home we’ve been talking about, but with a 15-year mortgage. If you got a 6.14% fixed rate (this week’s average for 15-year mortgages, according to Freddie Mac,) you’d pay about $192,000 in interest over the life of the loan, assuming you don’t pay it off early. But you’d pay about $496,000 with a 30-year 6.93% mortgage. That’s well over double the interest (totalling more than the price of the house!)

Again, a shorter-term loan is only a viable option if you can afford a higher monthly payment — $3,065 versus $2,378 if we use the comparison above.

What About Refinancing Later?

When rates are relatively high, refinancing your mortgage at a lower interest rate later sounds appealing. But you shouldn’t count on having that option. If the value of your home declines or your financial situation deteriorates, you may not qualify. And rates have been especially difficult to predict recently.

In fact, even though inflation has subsided significantly since 2022 (mortgage rates tend to rise with greater inflation risk,) a sense of uncertainty has kept mortgage rates much higher than experts had expected. Economists at the Mortgage Bankers Association now foresee 30-year rates will average close to 6.5% over the next few years. In 2023, they forecast they’d be in the 4% range by now.

The 30-Year Mortgage Is a Uniquely American Phenomenon

While it may not feel that affordable right now, the 30-year fixed-rate mortgage is a staple of the U.S. housing market because it’s relatively inexpensive. Interestingly, other countries haven’t adopted it the way we have, perhaps because they haven’t had the same levels of government support, research suggests.

It was actually a government intervention during the Great Depression of the 1930s that triggered the idea for a less expensive mortgage that offered homeowners more security. And to this day, government-sponsored entities including Fannie Mae and Freddie Mac keep the flow of money going by buying mortgages from lenders and selling them to investors.

The Right Choice For You

Whether you decide to go the traditional route or not, it’s important to make an informed choice. And besides the type of loan, there are many factors that will affect your costs, including the lender you use, your income and credit score, the size of your down payment, the “points” you may pay at closing (basically prepaid interest), and if you have to get mortgage insurance to protect the lender if you default.

Plus, you’ll have to pay home insurance and property taxes. (Using a calculator like ours will estimate how much it might add to your mortgage payment.)

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