ARM Mortgages More Affordable/Popular

It appears that the maligned Adjustable Rate Mortgage (ARM) is now staging a modest comeback. According to a recent survey, 10% of mortgage borrowers are projected to avail themselves of ARM loans in 2011, up from 3% in 2009. While the surge in popularity is rooted in the potential for savings, ARMs still come with a Buyer Beware warning label.

The appeal of ARMs is naturally rooted in lower rates. In exchange for giving up the certainty of a fixed interest rate, ARM borrowers can secure a significant short-term discount. According to the most recent Freddie Mac Primary Mortgage Market Survey,  the average variable rate is currently only 3.26%, compared to 4.81% for a 30-year mortgage. In addition, a 5/1 Hybrid ARM (which carries a fixed rate for the first five years, before reverting to a variable rate) rate is only 3.69%. While all mortgage rates have risen since October, fixed-rates are rising much faster than variable rates, which means that the cost of security (via a fixed interest rate) is rising.

The majority of borrowers choose hybrid ARMs because they come with both short-term security and an opportunity to achieve cost savings. Most lenders offer the standard 5/1 ARM, and others will also offer 3/1, 7/1, or 10/1 varieties. Generally speaking, the longer the fixed-rate period, the higher the interest rate. These loans are especially suitable for borrowers with short time periods, though long-term borrowers who are comfortable with risk are also good candidates.

Speaking of risk, the main one is that the variable rate will increase, resulting in higher monthly payments and undoing any short-term cost savings from the lower fixed rate. While this is a justifiable concern, there are a few mitigating factors. First, all ARM loans come with periodic adjustment caps (which limit the amount by which the interest rate can be raised each time) and a lifetime adjustment cap, which is basically an interest rate ceiling which will remain in place for as long as the loan remains outstanding. Not to mention that rates fluctuate over time in accordance with the business cycle.

Second, even if rates rise, there still exists the opportunity to achieve overall cost savings. For example, if you obtain a 5/1 ARM for 3.69%, and after 5 years, your variable rate rises to 6%, your average interest rate is still below the 4.81% that you would have paid if you had initially obtained a 30-year fixed rate mortgage. (Of course, the risk is that rates could keep rising and you could find yourself in the red). Finally, as long as you maintain a good credit score, you should have the opportunity to refinance into a fixed-rate mortgage at any time, thereby eliminating some of the risk.

You can see from the chart above that short-term rates have hovered at an attractive level for the last 20 years. While this might instill confidence in some variable rate mortgagers, the fact that short-term rates soared above 15% in the 1970s will certainly frighen others. In other words, while inflation (which bears on interest rates) has been stable for the last 20 years, it’s impossible to rule out higher inflation going forward.

In short, borrowers who are comfortable with risk and/or have short time horizons may want to give ARMs another look. Be advised that any savings should be pocketed in anticipation of higher future rates, rather than applied towards a larger mortgage.