There's a lot of talk going around about how borrowers should once again consider adjustable rate mortgages (ARMs). And no wonder -interest rates on ARMs are astonishingly low right now, with many lenders offering initial rates well below 4 percent.

That's a full percentage point or more below comparable fixed-rate loans. Yet borrowers have been reluctant to embrace ARMs again. For many, the big question is: Are they safe?

Many borrowers seem to think not. According to the Mortgage Bankers Association, ARMs have dropped from 20 percent of all mortgages in the early 2000s to less than 5 percent today. And according to Freddie Mac, virtually no one who recently refinanced a mortgage turned to an ARM - in the first quarter of 2010, only 5 percent of all borrowers refinanced into an ARM, and virtually none who previously had 30- or 15-year fixed rate loans.

Many still leery of ARMs

You can't blame them for being cautious. ARMs were widely blamed as a significant cause of the subprime mortgage crisis, and homeowners with ARMs continue to have some of the highest rates of underwater loans, defaults and foreclosures of all mortgage products.

But the market in ARMs has changed considerably since the subprime mortgage collapse, just like the entire mortgage industry. Many of the riskiest products, such as Option ARMs, have pretty much vanished from the landscape.

Lenders are being far more cautious about who they will lend to and on what terms. That may make it harder to get a loan, but it also means you're less likely to get a loan that's going to mutate out of control a few years down the road.

Are ARMs "exotic"?

Many borrowers think of ARMs as "exotic" loan products, a departure from traditional, straightforward mortgage lending with convoluted rules that can trip up the unwary borrower. But in reality, they're a well established, very traditional way of doing mortgages - in fact, in some countries, like Canada and Great Britain, they're the dominant form of home lending.

What made them exotic during the housing bubble was some of the variations lenders came up with in order to lend borrowers as much money as possible. Interest-only loans, where the borrower only needed cover the interest payments during the initial years of the loan; Option ARMS, where the payments didn't even have to cover all the interest; balloon loans, where the borrower made low payments for a few years, then was hit with a single large payment due several years down the road, and zero-down payment loans.

All these "exotic" loans had one thing in common to make them work - they assumed home values would continue to increase or, at worse, hold steady. Many of them also deferred a big chunk of the actual cost of the loan a few years down the road, on the assumption the loan could be refinanced before the big bill came due. When home values fell, the loans couldn't be refinanced and the homeowners got stuck with a big bill coming due with no way to avoid it.

"Standard" ARMs now the rule

The ARMs these days don't work like that. In some cases, you may still be able to obtain an interest-only loan if you're buying in a very stable market and can come up with a big down payment, but most borrowers will only have the option of a "standard" ARM - one where you start out with an initial interest rate for five years or so, and then it resets to a new rate based on prevailing market conditions.

Most recently, the weekly Freddie Mac interest rate survey had five-year ARMs averaging below a 4 percent initial interest rate, compared to just under 5 percent for 30-year fixed-rate loans. Some individual lenders were offering 5-year ARMs with initial rates below 3.5 percent if the borrower purchased discount points.

That's some significant savings. Using the Freddie Mac numbers, if you took out a $250,000 mortgage on a 30-year rate at 5 percent, your monthly payment would be $1342.05. With a 5-year ARM, the monthly payment for the first five years would be $1,194.53 - a savings of $148.41 a month, or a total of $8901.60 savings over the first five years before the loan would reset to a new rate.

Attractive to short-time owners

ARMs probably make the most sense for homebuyers who are confident they'll only be in the home for a few years - people who are on a solid career track and plan on upgrading to a nicer home in a few years or those who work in a business where they can expect to be reassigned to a new city every few years.

For them, an ARM covering the maximum length of time they expect to be in the home - they're available in ranges of one to 10 years before the initial rate resets - can make a lot of sense. They get the benefit of the lower interest rate while they live there, and then sell the house before the rate resets.

Sophisticated investors also like to use ARMs, in part because the savings are multiplied as the mortgage gets more expensive. These are the type who may obtain an ARM and periodically refinance when the rate adjustment comes due, because they figure they can save money over the long term.

For the average homebuyer, though, this is a somewhat risky approach. For one thing, 30-year mortgages are still near all-time lows, meaning that when you refinance in five or seven years, rates are likely to be higher than they are now - and quite likely higher than the current 30-year rate, which you could lock in today.

Also, remember that refinancing costs money - typically 2-3 percent of the loan amount, more if you purchase discount points. On our example above, refinancing your original $250,000 loan after five years would likely cost about $4,600 at a 2 percent rate - or about half of your $8,900 savings. You'd still be saving money, but that could be offset by having to refinance to a higher rate, which seems likely, given that rates are currently near record lows.

In summary then, if you're only planning to stay in a home for a few years, an ARM can still be a safe and sensible product for you. But unless you're a serious investor with experience in moving your money around, they may not be the best approach to long-term home ownership right now, despite the exceptionally low rates you could get for the next few years.

Published on February 27, 2008