Time to Give ARMs Another Shot?

By:
Kirk Haverkamp | July 30, 2011

Should you consider an adjustable rate mortgage? The flexible-rate loans got a bad reputation when they were associated with the collapse of the subprime mortgage market, but lately they’ve been making a comeback of sorts.

That comeback has been driven by one thing – low interest rates. Currently, the average initial rate on a 5-year ARM is only 3.25 percent, according to Freddie Mac, compared to 4.55 percent on a 30-year fixed-rate loan – a difference of 1.30 percentage points.
 
That’s as large as the gap has ever been – and far greater than the 0.25-0.50 percentage point difference that was typical in the years before the crash. The difference is even more stunning when you think of it in absolute terms – your initial monthly interest payments on the 30-year fixed-rate loan would be fully 40 percent higher than you’d be paying on the 5-year ARM, at current rates.
 

ARM advantages - and drawbacks

 
A lot of people think of ARMs as risky, complicated loans that can burn the unwary borrower. And in truth, they do present a potential hazard you won’t encounter with fixed-rate loans – that you could get stuck with a higher interest rate once the initial rate expires. But ARMs are hardly exotic – they’re as well-established and traditional as anything out there, and in many countries are the most common type of mortgage.
 
An ARM, of course, is a mortgage that starts out with a certain interest rate for a certain number of years, then resets to a new rate based on current market conditions. Their initial rate is typically lower than you can get on a comparable fixed-rate mortgage, because lenders don’t have to worry about possibly getting locked into a below-market rate for an extended period of time.
 
When the rates do readjust, they do so according to a predetermined formula, which has limits on how high and how fast they can reset. In some cases, they may even reset lower than the original rate, if market rates have fallen below what they were when the loan was originated.
 
What gave ARMs a bad reputation in this country is that they were combined with a number of other features designed to make mortgages as cheap and widely available as possible – zero-down payments, teaser rates, negative amortization, balloon payments, no-income documentation, etc. All of these worked as long as property values kept rising and the loans could be refinanced or the property sold once the rates increased or the balloon came due. But once property values began to fall, those options weren’t available anymore and subprime mortgages began to default in droves.
 

Borrowers who can benefit from ARMs

 
A traditional, no-frills ARM works very well for certain types of borrowers – typically, those who expect to be in their home for only a few years because they’re planning to relocate or move up to a better house. For that type of borrower, an ARM makes a lot of sense, since they’ll be selling the property before or shortly after the rate resets. And since ARMs are available in a variety of lengths – initial rate periods are typically one to seven years – borrowers can choose one that matches the length of time they expect to own the home.
 
ARMs are also popular among certain borrowers with high-end mortgages who are sophisticated about finances. These include “serial refinancers” who refinance to a new ARM every few years. They figure that, even though mortgage rates may go up or down, an ARM will always be cheaper than a fixed-rate loan, so it balances out over time. Plus, having a large mortgage means the advantage they get from a lower interest rate on an ARM is magnified.
 
Even when overall rates are at historical lows such as they are now, certain borrowers can benefit from serial refinancing of ARMS. People who wish to pay down their mortgages quickly often opt for an ARM, so that more of their payments go toward reducing the principle on the loan. Even if they haven’t paid off the entire loan by the time the rate resets, the additional money they’ve been able to put toward principle may mean they’re still in a better position financially, even if they have to refinance the rest at a somewhat higher rate.
 

Stable home prices are key

 
To be sure, you don’t want to choose an ARM unless you’re confident your home value will at least remain stable, so that you can refinance or sell when needed. For that matter, you don’t want to even buy a home unless you’re confident it will hold its value, but at least with a fixed-rate mortgage you won’t have to deal with the possibility of rising interest rates and monthly payments once the rate resets.
 
If you’re looking to save money on your mortgage but are reluctant to take on an ARM, one other option that compares favorably in terms of interest rates is the 15-year fixed-rate loan. According to Freddie Mac, those currently average 3.66 percent – compared to the 3.25 percent average on 5-year ARMs.  However, your principle payments will be considerably higher – ARMs typically amortize on a 30-year schedule – so you have to take that into account as well.
 
ARMs aren’t for everyone and most people who plan to stay in their home for a decade or more are probably better off with a fixed-rate mortgage. But for the right kind of borrower, they can be part of a sound financial strategy and are well worth looking into.

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