Adjustable-rate mortgages sometimes seem like a ticking time bomb because the attractive interest rate only lasts for a set period — usually three, five or seven years — before it begins fluctuating annually. Thanks to the lower rates they offer initially, though, ARMs can be a better alternative to fixed-rate mortgages in some circumstances.
ARMs are a good bet if the rate is markedly lower than for a 30-year fixed loan, and the borrower plans to sell the house or pay off the mortgage before the term expires and the rate adjusts, says Greg McBride, senior financial analyst with Bankrate.com.
Margie Hofberg, a mortgage broker and president of Residential Mortgage Center in Rockville, kept a three-year ARM for seven years before disposing of the loan last year. Even with annual fluctuations, her rate averaged just 5.13 percent the entire time.
Such loans, McBride said, benefit borrowers who relocate frequently because of their jobs. Families that expect their incomes to rise by the time the loan resets — perhaps because a spouse returns to the work force when the children begin attending school — can also benefit from an ARM.
As it happens, however, 30-year fixed-rate mortgages currently offer borrowers the best value.
“There’s very little benefit to ARMS right now because the interest rates aren’t that different,” McBride says. According to a recent Bankrate.com survey, a seven-year ARM averaged 5.86 percent compared with 5.76 percent for the 30-year fixed rate, which is near a historic low. At 5.36 percent, five-year ARMs didn’t offer much savings either.
Some financial experts expect ARMs will become more attractive particularly for large mortgages. Skittish banks are wary of being stuck with jumbo loans locked in at today’s low rates because they expect interest rates to rise eventually.
“Lenders don’t want the interest rate risk, so they are going to make the adjustables more attractive,” says Tim Wilson, president of Chantilly-based Long & Foster Cos.
For borrowers, ARMs do carry a risk — bigger mortgage payments if rates are higher when the loan rests, although rate changes are typically capped at 2.5 percent each year or up to 5 percent for the life of the loan, Hofberg says. Those caps, however, may not protect borrowers from being stuck with a loan they can no longer afford.
There is also the risk, as many borrowers discovered last year, of being unable to refinance a suddenly burdensome ARM. Trapped between higher rates and lower home values, these borrowers couldn’t refinance when they owed more than their houses were worth. For many, that was a recipe for foreclosure.
If there’s a lesson to be learned from the recent foreclosure crisis, it’s that “ARMs should not be used to make the home affordable,” says McBride, who recommends using a 30-year fixed rate mortgage as a gauge. “If you cannot afford the home at a 30-year fixed rate, it’s time to look for a different house, not a different loan.”
