Banks Are Selling ARMs; Should You Be Buying?

Adjustable-rate mortgages (ARMs) may be the last holdout for low mortgage rates. Banks have a good reason for wanting ARM mortgage rates to appear attractive, but you need to decide whether or not you should bite at that lure.

Changing Mortgage Dynamics

You've probably heard that mortgage rates are rising. That's mostly true, but there are exceptions. While Freddie Mac reports that 30-year fixed mortgage rates have risen by more than 1 percent so far in 2013, 1-year ARM mortgage rates are roughly where they were at the start of the year. So, if you think low mortgage rates are a thing of the past, you might be surprised to find that those 1-year ARM rates are still just 2.59 percent.

This is an example of how dynamics within the mortgage market can change - it's not just a question of whether mortgage rates are rising or falling. As the gap between different types of mortgage rates widens or narrows, the relative attractiveness of those various mortgages also changes. Over the course of 2013, the gap between 30-year fixed mortgage rates and ARM mortgage rates has more than doubled, from 0.79 percent to 1.87 percent.

That widening gap makes ARM mortgage rates look relatively more attractive, and the marketplace has responded by showing renewed interest in ARMs. According to the Mortgage Bankers Association, as of early December ARM applications represented 8 percent of all mortgage application activity. That may not sound like much, but a year ago ARM applications were just 3 percent of all activity, again according to the Mortgage Bankers Association. In other words, ARM applications have more than doubled as a percentage of total application activity.

The question is, should you join this trend of growing enthusiasm for ARMs?

Why Banks Want You to Choose an ARM

Banks would certainly like you consider an ARM. Bloomberg News recently reported that some banks are keen on selling ARMs because those loans hedge their risk exposure to higher interest rates. This may have something to do with why ARM mortgage rates have remained so low, even as other rates have started to rise. With low mortgage rates having been a function of an unusually weak economy and an extraordinary degree of Federal Reserve intervention, it is natural to assume that rates will rise as things return more to normal. Banks are willing to take a lower rate up front in return for getting a mortgage rate that will respond to rising interest conditions down the road, rather than being locked into what are still relatively low mortgage rates for 30 years.

Of course, just because ARMs may be in a bank's best interest does not mean they are right for you. ARMs are riskier than fixed rate mortgages, because you don't know for sure what your future monthly payments will be. ARMs can be useful for certain situations, but there are a number of things you should know before you sign on the dotted line.

5 Things to Know Before You Sign Up for an ARM

The rule of thumb with ARMs is that the longer you plan to take to repay the loan, the more risk you will be exposed to because interest rates will have more of a chance to rise. Here are five conditions that will tell you whether or not you can effectively limit that risk:

  1. What is the rate differential? As mentioned above, the spread between 30-year fixed mortgage rates and ARM mortgage rates has recently widened to 1.87 percent. This represents your initial cushion against rising rates in the ARM - if your rate were to rise by 1.87 percent, you would be even with where you would be had you signed up for a 30-year fixed rate loan to begin with. Over nearly 30 years of history, that spread has averaged 1.7 percent, so 1.87 percent is a little better than average.
  2. What are the reset terms? Adjustable rate mortgages have specific time periods at which rates reset, and parameters for how much rates can change at any one time. Those terms will tell you how quickly your mortgage rate -- and thus your monthly payments -- could rise.
  3. What are your options for paying off the mortgage early? ARMs can be attractive if you plan to pay the mortgage off early, either because you expect to move or have a large amount of money coming your way. Paying the mortgage off early allows you to limit how long you will be exposed to rising interest rates. The question you have to ask yourself going in is just how solid those future plans are.
  4. How much home equity do you have? If you are planning on paying the mortgage off early by selling the home, it helps to have a healthy cushion of home equity. That way, even if prices decline, you should have enough from the sale proceeds to pay off the mortgage.
  5. Is there a prepayment penalty? The strategy of limiting risk by paying the mortgage off early depends on there not being too onerous a prepayment penalty, so make sure you know that aspect of your mortgage terms going in.

Banks look at ARMs as an opportunity to hedge against rising interest rates. Knowing that, you shouldn't sign up for an ARM unless you fully understand how to limit how much of that same risk you are taking on.

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