Choosing a Low Down Payment Mortgage: ARM or Fixed?

[Nick Gray]

Hi Everyone, 

I am in the process of purchasing my first deal, a duplex in Exeter, NH, for $265K. My plan is to house hack by owner-occupying one side with a roommate and (hopefully) living for free. I have just enough money for a 15% down payment and I have been approved for several first time homebuyers' programs, of which I have found the following two options to be the best offers.

Option 1: 30-Year Fixed Rate @ 3.875%, 15% or $39,750 Down Payment, ~$2,500 in loan-associated closing costs (origination fees, appraisals, etc.), $160/month of PMI that can be removed at 78% LTV, $1,219 monthly payment w/ PMI and $1,059 without it.

Option 2: 30-Year 3/1 ARM @ 2.875% to start, 3% or $7,950 down payment, no loan-associated closing costs (origination fees, appraisals, etc.), no PMI, 7.875% interest rate cap with increases of no more than 1% per year, $1,066 monthly payment for the first three years.

I understand that the interest rate risk of an ARM can be very dangerous and that, with interest rates on the rise, it might be more prudent to lock in at a 3.875% fixed rate. However, I want to hear from others how this ARM (Option 2) compares to my best fixed rate offer (Option 1). First, the 3% down payment and lack of loan-associated closing costs would keep $34,300 in my pocket at closing for me to fund another deal in the short-term. Second, the low interest rate and lack of PMI would make for a monthly payment that is $154/month cheaper than Option 1 while I am above 78% LTV and a monthly payment roughly the same as Option 1 once PMI is removed.

If it is relevant to this financing decision, I am fortunate enough to have a W2 job that, combined with a frugal lifestyle, lets me save $3,000/month currently. If I live in this duplex with a roommate, I should be able to save $3,800/month. This would allow me to pay down my mortgage early under either of these two financing options, something that would enable me to remove PMI quite soon or minimize my exposure to interest rate increases.

Which option would each of you choose were you to be in my position? Should I take the up-front savings and additional leverage in exchange for interest rate risk or pay an upfront premium for long-term rate stability? 

Thanks for the help!

[Axel Ragnarsson]

Hey Nicholas,

Congratulations on finding a property - Exeter is a great place to buy. I would personally opt for the fixed rate.. interest rates will continue to rise and who knows when they will return to the low rates that borrowers are being offered now. If the lender will remove MI from the loan at 78% LTV and you are putting 15% down, then you should reach that threshold rather quickly if you are buying the property for any amount that is under market. One of my personal goals is to secure as much debt as I can while interest rates are low as well, which may further bias me to the fixed rate product