Numbers Game: Choosing Adjustable Rate Mortgage (ARM) Terms

With current home mortgage rates still quite low, adjustable-rate mortgages (ARMs) are losing their appeal. However, they still have their uses -- if you know how to use them to your advantage and how to choose the right ARM terms.

According to the Mortgage Bankers Association, ARMs represent about 8 percent of all mortgage applications these days. However, while they may be in the minority among options, ARMs remain valuable tools when used in the right situation. Given how much lower ARM mortgage rates are than fixed mortgage rates, ARMs are at least worth considering. However, any sound financial decision goes beyond simply choosing between fixed and adjustable rates. The following are some guidelines on making the best use of ARMs.

Fixed or adjustable?

Here are four key factors in choosing between fixed and adjustable rates:

  1. Rate spread. At least initially, ARMs currently ffer the best mortgage rates. The trade-off is that you run the risk of the rates rising in the future. A big part of this choice comes down to how much you're rewarded for taking that risk. The wider the spread between fixed and ARM mortgage rates, the more you are compensated for the risk that rates will rise. According to mortgage finance company Freddie Mac, 5/1 ARM mortgage rates are currently 1.24 percent below 30-year fixed mortgage rates, and 1-year ARM mortgage rates are 1.84 below 30-year fixed rates. A year ago those spreads both were below 1 percent, so the compensation for the risk inherent in ARMs has become more attractive.
  2. Ability to repay early. ARMs are a popular option for people who anticipate being able to pay off the mortgage early, because the sooner you end the mortgage, the less risk of rising interest rates you face.
  3. Overall level of mortgage rates. It's not just the spread between fixed and ARM mortgage rates that matters -- the absolute level of rates is also important. Despite rising over the past year, current home mortgage rates are still unusually low, which is a big reason why locking in fixed rates is so popular right now.
  4. Interest rate outlook. While it matters that current home mortgage rates are lower than they have generally been in the past, you should also consider the outlook for the economy. If you think, as some economists do, that the US is in an extended period of slow growth and low inflation, you may be more comfortable assuming that mortgage rates will stay unusually low for the foreseeable future.

Key elements of an adjustable-rate mortgage

Deciding on an ARM is just the first stage of the process. After that, you have to choose the right adjustable-rate terms. Here are the key elements:

  1. Initial term length. The most common options are for ARMs that start to reset after one year, and those that don't start to change until after the first five years. If your goal is to lock in a low initial rate and then pay off the mortgage before it resets, a five-year initial rate period gives you more time to accomplish it.
  2. Reset frequency. A 5/1 ARM holds the initial rate for the first five years, and then resets every year thereafter. A 5/5 ARM holds the initial rate for the first five years, and then resets at five-year intervals thereafter. Having an ARM that resets less frequently can make the loan a little more stable, however, it can work against you if a reset period occurs during an upward spike in interest rates.
  3. Reset limits. Some loans may have a limit on how much the interest rate can rise at any one reset period. These loans are likely to have less of an initial rate discount than those without a reset limit, but choosing a loan with a limit may be one way of reducing your risk.
  4. Prepayment penalty. Some lenders charge you if you pay them back early, making it important to know if your strategy is to limit the risk of rising rates by paying the mortgage off before it is due.
  5. Initial rate. Once you choose what type of ARM you want, do not assume all rates are the same. Compare mortgage rates to get the best deal to improve your chances of benefiting from an ARM.

Because they entail the risk of variable interest rates, ARMs are not for everybody. You should only choose an ARM if you have a thorough, comfortable understanding of all the variables. Since not all ARMs are the same, choose the terms that work to your greatest advantage.

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