Time for ARMs?

Whenever mortgage rates increase – even a tiny little bit – many borrowers begin to think about adjustable rate mortgages (ARMs). After all, why pay more for a fixed-rate loan when an ARM mortgage could be a big money saver

The key expression, of course, is could be. In some cases ARM mortgages work very well, when considering adjustable financing you have to look at the potential pros and cons.

At the time of this writing, 30-year fixed-rate loans are available at roughly 4.12 percent while a 5/1 hybrid ARM can be had for 2.98 percent. That's a difference of 1.14 percent. In money terms, if you borrow $150,000 with the fixed-rate loan you'll pay out $29,525 in interest during the first five years versus $21,158 for the ARM. That's a difference of more than $8,300.

ARMs and Up-Front Savings

Another way to compare the two options is to look at the monthly cost for principal and interest. For the fixed-rate loan, the monthly expense is $727 -- versus $631 for the ARM.

There has to be a catch, though, and sure enough there is: after five years, the interest level for the fixed-rate loan remains steady and unchanged while the rate for an adjustable is likely to go up or down. Given that 2.98 percent is a ridiculously low rate, it would not be surprising to see the ARM interest level rise.

Let's say that the adjustable rate is allowed to increase as much as two percent with the first adjustment and does so. That brings the rate to 4.98 percent. After five years the remaining ARM loan balance is $133,311. The loan has 25 years remaining so the new monthly payment for principal and interest in year six is $778. The cost for the fixed-rate loan remains unchanged at $727.

Many adjustables allow as much as a two percent annual interest-rate increase and a six percent lifetime cap. In the worst case, the ARM described here could go up to as much as 8.98 percent in year eight if rates rise to that level.

Time Is (Probably) on Your Side

For many borrowers, the truth is that future rates are not an issue. The National Association of Realtors (NAR), for example, points out that on average the typical homeowner purchases a replacement property after nine years., with younger and first-time buyers keeping their homes for shorter periods and older buyers remaining in their homes for longer periods. Mike Fratantoni, Chief Economist with the Mortgage Bankers Association, explains that it's difficult to estimate how long loans remain outstanding because people rush to refinance when rates are low but then hold onto mortgages as rates rise. Also, younger people tend to move more frequently then older ones. The result is that borrowers average a move every seven years or so, but that number can vary with interest rate changes.

So the pros and cons look like this:

If you don't like the risk of possibly higher rates, or if you're buying on the edge of affordability, then you will likely be more comfortable with a fixed-rate mortgage. On the other hand, an ARM can mean money in the bank -- at least at first.
  • For details and specifics comparing ARMs and fixed-rate mortgages, speak with your mortgage loan officer.
  • Go with an adjustable-rate product and you'll get a lower rate. That lower rate can mean real savings during the first few years of the loan term, the so-called "start" period.
  • You can get ARMs with various start periods. The usual arrangement is a start period and then one-year adjustments for the life of the loan. Typical combinations include 1-year ARMs as well as 3/1, 5/1, 7/1 and 10/1 products. Recently a new product has been introduced, the 15/15 ARM.
  • The longer the start period, the smaller the discount when compared with fixed-rate financing. The shorter the start period, the faster the loan will reach its first adjustment and the first adjustment could lead to a higher rate.
  • We don't know what the future will bring. You might expect to live at a given property for only a few years but plans can change.

​If you don't like the risk of possibly higher rates, or if you're buying on the edge of affordability, then you will likely be more comfortable with a fixed-rate mortgage. On the other hand, an ARM can mean money in the bank -- at least at first.

For details and specifics comparing ARMs and fixed-rate mortgages, speak with your mortgage loan officer.

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