Adjustable-rate mortgages have been in the doghouse for years, shunned by borrowers who heard horror stories about homeowners whose ARM rates soared in the '00s, driving monthly mortgage payments through the roof. Earlier this year, the Mortgage Bankers Association reported that only 4% of mortgage applicants were seeking ARMs.
But maybe it's time to reconsider. For some borrowers, an ARM can be cheaper than a fixed-rate mortgage. Also, ARM rates are enticingly low right now but could rise as the economy improves. Annual and lifetime caps based on today's low starting rates would prevent a borrower's future ARM rates from going too high.
As the name implies, an adjustable-rate mortgage has a floating interest rate. Typically, it starts out low -- lower than you'd pay on a fixed-rate loan that charges the same rate for its lifetime. After an initial period of one to 10 years, the ARM rate adjusts every 12 months. The new rate is figured by adding a "margin," such as 2.75 percentage points, to an index such as the rate paid by a specific bond.
The borrower saves money by paying a lower rate in the initial period than on a fixed-rate loan. But there is a risk the ARM rate will someday go higher than the borrower would have paid with a fixed-rate deal. In the past few years, rates on 15- and 30-year fixed-rate loans have been so low that most borrowers figured it was better to lock in a fixed rate than take chances on an adjustable one.
So why look at ARMs now? Mainly because ARM rates are likely to rise, so that today's ARM is probably a better deal than the one you might get in a year or two. ARMs come with caps that typically prevent future adjustments from rising more than 2 percentage points a year, or 5 or 6 points over the loan's life. If you start at an exceptionally low rate today, like the 2.7% average for five-year ARMs, you'll never pay more than 8.7%, which is not especially high by historical standards.
Of course, a rise that high would cause a dramatic increase in your monthly payment, so it would make no sense to get this ARM if you really thought rates would go that high and stay there. You'd be much better off getting today's 30-year, fixed-rate loan, averaging 3.5%.
This means the best candidate for an ARM is the borrower who expects to pay off the loan during the initial period, such as five, seven or 10 years, while the rate is fixed.
This would include one who is buying a home that is likely to be sold during that period.
It would also include a home buyer, or a homeowner who is refinancing an older mortgage with a high rate, who is capable of making extra payments to retire the loan ahead of schedule.
A homeowner who is refinancing, for instance, may have already reduced the original loan balance substantially. With a lower interest rate on the ARM and a modest loan balance, it might be possible to pay off the new ARM during the initial period with a monthly payment similar to that of the old loan.
In the same way, a buyer with plenty of resources could make extra principal payments to pay the loan off while the rate remains low.
Even if these borrowers failed to retire the debt during that initial period, reducing the debt through extra payments would reduce the pain if the rate did rise in the future.
The key, then, to making an ARM work: Be sure you can afford the payment at the maximum rate the ARM could charge, or make extra payments so you never face a burdensome payment.