Borrowers have forsaken adjustable-rate mortgages. In its latest survey, the Mortgage Bankers Association said ARMs accounted for just 2.3 percent of loan applications for the week ending May 8, down from more than 30 percent in the middle of the decade.
Is the ARM really such a bad choice?
For most people, it probably is. But ARMs may be suitable for a handful of borrowers who shop carefully, don’t expect to keep their loans for long or are willing to take on substantial risk to bet that interest rates will stay low.
Most borrowers are better off with fixed-rate mortgages, which are terrific bargains these days. The 30-year fixed loan averages about 5 percent, and the 15-year variety just 4.8 percent, according to the BankingMyWay.com survey.
Meanwhile, one-year ARMs start at about 5 percent. As a rule of thumb, an ARM should start about 2 percentage points lower than a fixed loan to be attractive, and even then it may not be.
The one-year ARM charges the advertised rate for 12 months, then adjusts up or down by adding a given number of percentage points, or “margin,” to the rate on an underlying index. So long as the index stays low, your rate will stay low. Many ARMs cap rate changes at 2 percentage points a year and 6 points over the life of the loan.
Three-year, five-year and seven-year ARMs keep the initial rate for the stated period, then reset the rate every 12 months. Bank of America (Stock Quote: BAC), has an ARM that charges just 3.875 percent for the first five years, while Wells Fargo (Stock Quote: WFC) has a similar loan charging 3.75 percent.
Use the BankingMyWay.com search tool to find good rates, then plug the numbers in to the Adjustable Rate Mortgage Calculator and Arm vs. Fixed Rate Mortgage calculator to see if savings would justify the risk of an ARM.
Once you locate a few ARMs with attractive rates, you’ll have to contact the lenders to get critical details. You must know the annual and lifetime reset caps, the margin and index used in the adjustments.
Knowing the index is essential, as that will tell you what your ARM would charge if it were to reset now, providing a sense of the risk you’d face. One popular index, the One-year Treasury Constant Maturity currently sits at 0.53 percent, meaning an ARM with a 2.75-point margin would adjust to 3.28 percent if keyed to this index, a substantial savings compared to fixed loans at 5 percent.
But with a new one-year arm starting around 5 percent you could eventually pay 11 percent if it carried a 6-point cap.
Another widely used index, the six-month LIBOR, is now around 1.65 percent. A loan with a 2.75 point margin would adjust to 4.4 percent.
An ARM may be the choice of the borrower who strongly believes the index rates will stay down, keeping the ARM rate lower than one would pay with a fixed-rate loan. An ARM could be worth considering in a couple of other situations:
The prepay option. A borrower who expects to make extra principal payments to pay the loan off early can benefit because prepayments will reduce the required monthly payments after future resets. You don’t get that benefit with fixed mortgages.
Short-term borrowers. You might choose an ARM if you expect to move or refinance in a few years, and if you think rates will stay low during that period. The short time horizon makes risks of future rate hikes less important. A five-year ARM might be good in this situation.
A small mortgage. The prospect of facing higher monthly payments someday is less worrisome if you could easily afford them, making it safer to bet that rates will stay low.
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