A Fresh Look at ARMs

In recent years, low interest rates on fixed mortgages caused adjustable rate mortgages (ARMs) to fall out of favor. According to the Mortgage Bankers Association, as of the last week of May, ARMs represented just five percent of all mortgage applications. However, despite their current unpopularity, ARMs should not be dismissed completely. There are some situations in which they are well worth considering – especially as interest rates start to rise.

Wait a minute – aren’t rising interest rates supposed to be bad for ARMs? Yes, if you already have a mortgage. However, if you are thinking about getting a mortgage in the future, the higher interest rates go, the more attractive ARMs should become.
The following is a review of why ARMs have fallen out of favor, and why you shouldn’t dismiss them completely.

The Case Against ARMs

The case against ARMs is two-fold:

1. In general, do you want to introduce an element of variability to your home mortgage payment? If you can lock in a payment you can afford over the life of the loan, you don’t need to take on the risk that an ARM might suddenly make your home unaffordable.

2. Current home mortgage rates are extraordinarily low. At these levels, they would seem to have more room to rise than fall, so the risk/reward trade-off of ARMs is not favorable.
Despite those arguments, there are cases where ARMs can make sense.

When ARMs Make Sense

When you look at current home mortgage rates, it’s no longer a question of why ARMs represent such a small portion of mortgages being written these days. The question is, why is anyone choosing these loans at all?

Well, there can be very sound reasons for choosing an ARM, even in a low interest rate environment. The case for ARMs gets more broadly compelling at higher interest rates. Here are four situations in which an ARM can make sense:

1. You plan on moving in a few years. ARM rates are typically lower than 30-year fixed mortgage rates. In fact, according to data from mortgage finance company Freddie Mac, this spread has widened since 2007, giving ARMs an even greater initial rate advantage. Of course, the risk is that the ARM rate will vary, but you can minimize that risk by choosing a hybrid ARM -- an ARM with a fixed rate for the first three-to-ten years. If you plan to sell your current house before the ARM rate is due to re-set, you can take advantage of the lower initial rate without facing the risk of the loan re-setting at a higher mortgage rate. Just make sure that your personal situation and real estate market conditions will allow you to follow through on this plan.

2. You plan on paying off your mortgage in a few years. Even if you aren’t planning to move, you can take advantage of the dynamic described above if you expect to have the means to pay off your mortgage within a few years – for example, if you have an employment bonus or some other lump sum payment coming in the foreseeable future. The wisdom of this move depends on your degree of confidence that those future funds will come through.

3. You have the option of paying off the mortgage in a few years. You may not need to wait for some future payment – you may already have the means available to pay for your new home in cash, but choose not to do so for liquidity purposes. With 5/1 ARM rates below 3 percent, you may choose to hold onto your liquidity, and only pay off the loan if the interest rate rises significantly.

4. Interest rates have been rising. Rising interest rates spell trouble if you already have an ARM, but for future borrowers, the higher rates go, the more attractive ARMs become. Basically, borrowing with an ARM is a bet that interest rates will be stable or decline over the life of your loan, and the higher interest rates are, the greater the odds are that this will be the case.

Be advised, though, that even though mortgage rates have been rising lately, they are still well below their long-term average. According to Federal Reserve data, the long-term average for 30-year mortgage rates is about 8.6 percent, so current home mortgage rates may have a ways to go before the interest rate odds favor an ARM. Still, just as 3.5 percent mortgage rates were hard to imagine just a few years ago, it’s always possible that before long the market will see rates high enough to make ARMs truly attractive.

In all the cases above, you need to make sure you are thoroughly familiar with key terms of the loan, including the initial fixed-rate period (if any), the interest-rate re-set frequency, and whether there is a penalty for paying off the mortgage early.

ARMs add an element of unpredictability to your future mortgage payments, so you should not consider an ARM unless you fully understand what could happen to those payments. However, if you understand and are prepared for that risk, ARM rates could save you a substantial amount of interest expense over the course of your mortgage.

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