Weighing the Pros & Cons of 5-Year ARMs
By: Jeff Brown

NEW YORK (MainStreet) — Not long ago, shifting market conditions led us to take another look at the merits of five-year adjustable-rate mortgages, despite the bad reputation ARMs got during the mortgage debacle a few years ago. Now the five-year ARM looks even better – assuming you’re the right kind of borrower.

According to the BankingMyWay.com survey, five-year ARMs charge a mouth-watering average interest of 3.175%, while 30-year fixed-rate mortgages charge 4.657%. Rates on five-year ARMs have dropped considerably in just the past couple of months. It used to be that the gap between the five-year ARM and the 30-year fixed hovered around one percentage point. Now the gap has grown to 1.5 percentage points.

If you borrowed $300,000, you’d pay $1,293 a month on today’s five-year ARM, compared to $1,548 on the 30-year fixed loan, saving you $15,301 over five years. And because of the low interest, a bit more of each month’s ARM payment would go to principal, so that after five years you’d owe $267,588 on the ARM, compared to $274,118 on the fixed loan. Together, the extra equity and the interest savings would make you $21,861 richer after five years if you chose the ARM. Use the ARM vs. Fixed Rate Mortgage Calculator to check your own numbers.

What’s the downside? As always, it’s that the interest rate on the ARM could shoot up after the first five years. At that point, the rate resets every 12 months, so you could end up paying a much higher rate than you would have if you’d taken out the fixed-rate loan to begin with.

But even if the ARM interest rate were to rise to the maximum – increasing by typically two percentage points in each reset, and six percentage points over the loan’s life – it could take several years for the higher rates to offset the savings in the first five years.

The five-year ARM could well be cheaper than the 30-year loan for seven or eight years, and perhaps longer. If you don’t think you’ll stay in the home longer than that, the ARM is worth a serious look. For a longer term, the fixed loan is probably better, as today’s fixed rate, though not at rock bottom, is very low by historical standards.

The key is to be sure you’re not jeopardizing your financial future by counting on low rates down the road. Use the BankingMyWay search tool to find the best deal, and study the loan terms to see just how high your rate could go in future resets. Then use the calculator to figure the highest monthly payment you could possibly face in the future. If the worst case is out of your comfort zone, go with the fixed-rate loan.

And if you do get the ARM, think about plowing those monthly savings into extra principal payments. That will reduce the loan balance after the first five years, cutting your monthly payments once the resets begin.

—For more ways to save, spend, invest and borrow, visit MainStreet.com.

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