Time to Give ARMs a Fresh Look?

By:
Kirk Haverkamp | June 30, 2011

Is it time for borrowers to start thinking about adjustable-rate mortgages again? The advice of many mortgage and financial experts is a definite yes.

Interest rates on ARMs are absurdly low right now, even compared to the all-time lows that fixed-rate mortgages are approaching once again. Freddie Mac reported last week that the average rate on 5-year Treasury indexed ARMs fell to 3.25 percent, the lowest they’ve ever been and a full one-and-a-quarter points lower than a 30-year fixed-rate loan at 4.50 percent.
 
That’s a huge difference – prior to the market crash in October 2008, the spread between the interest rates on a 30-year fixed-rate mortgage and a 5-year ARM typically ranged between a quarter and half a percentage point. Considering that 30-year loans are already near historic lows, the additional 1.25 percent difference offered by the 5-year ARM is absolutely mind-boggling.
 
Of course, many borrowers are spooked by ARMs because of all the subprime borrowers who got trapped in loans they really couldn’t afford during the housing bubble. And to be sure, there are risks associated with ARMs, particularly if interest rates rise significantly between now and the time your rate starts to readjust.
 
The big problem with ARMs during the housing bubble though, was the way they were bundled with such “exotic” features as no-money down, negative amortization and balloon payment mortgages. Such loans worked as long as home values kept rising and borrowers could refinance when it was time for their interest rate to readjust or their balloon payment came due, but when home values dropped, the whole system fell apart.
 

Looking at long-term costs, interest rates

 
Nowadays, such exotic loans are virtually extinct. What you have instead are “plain vanilla” ARMs where you pay a fixed interest rate for a certain number of years, after which it resets to a new rate according to a predetermined formula. Even if mortgage interest rates rise, your own rate increases are capped according to that formula, so you can know what your maximum rate can be for each year of the loan.
 
Of course, interest rates can rise fairly sharply. You could see your rates rise by 10 points or more over a period of several years, particularly if an inflationary period sets in that drives up interest rates overall. That’s why ARMs are usually recommended only for people who plan to sell the home before that can happen or who are confident they will be able to refinance into better terms if it does.
 
In the current market, you’re probably better off going with a fixed-rate mortgage if you’re planning to stay in the home longer than 8-10 years or so. Even if you’re confident you could refinance a 5- or 7-year ARM when it resets, current fixed rates are so low by historic standards that you have to consider what sort of rates will be available five to seven years down the road.
 
If you’re only planning to be in the home for 5-7 years, an ARM with an initial rate for that long has obvious advantages. However, if you think there’s a possibility you might be there a bit longer, say another 1-3 years, you need to weigh the possibility of rising interest rates in those years against whatever savings you might realize up front to determine if an ARM makes sense for you.

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