Home Loans: A Call to ARMs?


Original Post Date: May 28, 2011

By: Annamaria Andriotis

One of the signature loans of the housing boom—the adjustable-rate mortgage—is looking more attractive than it has in years. For some buyers, it may be an even better deal than a fixed-rate mortgage.

ARMs typically offer buyers a lower rate for a set period of years, after which rates rise or drop each year, depending on prevailing interest rates. The loans lost favor during the financial crisis, when their rates weren’t much better than those for fixed-rate mortgages.

But now, as interest rates hover near historic lows, the “spread” between the rates on the most popular adjustable and fixed-rate loans is on pace to be the widest it has been in eight years, according to HSH Associates, which tracks mortgage rates.

For an ARM to make sense, a borrower has to be comfortable taking a gamble that interest rates won’t rise, or that he can sell the house before they do. It is a dicey bet now: Rates have been mostly on a downward slide for the past three years, mirroring the recent plunge in 10-year Treasury rates, and seem to be about as low as they are going to get. Many economists are predicting rates will rise in coming years.

That is why ARMs make sense mostly for borrowers who expect to be in a home for a short time. “If the household is truly intending to stay only for five years, they should take the five-year ARM,” says Stuart Gabriel, director of the Ziman Center for Real Estate at the University of California, Los Angeles.

The average rate on a so-called 5/1 ARM—which carries a fixed rate for five years, then adjusts every year thereafter—is currently 3.4%, nearly 0.4 percentage point lower than January’s rate, according to data compiled by HSH Associates. The average rate on a 30-year fixed-rate mortgage is 4.72%, just 0.22 point lower than in January.

That spread of 1.32 percentage points is big enough to save some buyers thousands of dollars in mortgage payments during the first five years of a mortgage. At current rates, a borrower with a $400,000 5/1 ARM will pay about $65,000 in interest over the first five years, while a borrower with a 30-year fixed-rate mortgage will pay around $91,000 in interest during that same period.

While ARMs are often cheaper than fixed-rate mortgages, this wide a spread—partly the result of low demand—is unusual, says Keith Gumbinger, vice president at HSH Associates; the historical average is 0.59 percentage point.

Here is how a 5/1 ARM works: After the first five years, rates typically adjust each year and can move either up or down. During the sixth year, the maximum amount they can increase by is 5 percentage points. Each year after that the rate can move by 2 percentage points, as long it doesn’t surpass the loan’s maximum lifetime cap, which is 5 percentage points above the initial fixed rate. That means the lifetime cap on a loan made today at 3.4% would be 8.4%.

During the housing boom, some buyers flocked to ARMs, hoping to sell their houses at a profit before rates reset. When prices started falling, the gambit stopped working. And after the monthly payments shot up, many borrowers found themselves facing higher-than-anticipated bills. The problem was especially acute with so-called option ARMs, which allowed borrowers to make a minimum payment that didn’t cover the interest due and led to a rising loan balance.

When the housing market crashed, ARMs—and the lenders and brokers who sold them—shouldered part of the blame. Last month, ARMs made up some 6.5% of the total mortgage market, according to the Mortgage Bankers Association, down from roughly 18% in April 2007.

The risk to borrowers is that the new payments after the fixed-rate period are suddenly unaffordable. While there isn’t a way to control for a job loss or other unforeseen loss of household income, it doesn’t seem likely that interest rates will spike so high in coming years that borrowers will end up paying the maximum, says Cameron Findlay, chief economist at LendingTree.com, an online marketplace that connects consumers to lenders. He expects the government will keep some sort of control over the rate environment as home values and employment recover.

ARMs are most suitable for buyers who are dead certain they are going to sell within the fixed term of the mortgage, and the recent housing market crash has offered plenty of reasons to cast doubt. While most experts expect the housing market to be quite different five years from now, it may be hard to take a risk predicated on being able to sell your house exactly when you want.

They also can make sense for some homeowners who plan to refinance, especially those who are a few years away from retirement and plan to sell their home then, Mr. Gumbinger says. They could recast their remaining loan into a 5/1 ARM with a lower fixed rate than their current mortgage, which in turn would lead to smaller monthly payments. The money they save could be put to work in a retirement account, he says.

ARM or no, most homeowners don’t stay put too long. On average, individuals who sold their homes in 2010 had owned them for eight years, according to the National Association of Realtors.