Adjustable-Rate Mortgages Look Good. Should You Bite?

You can get a fixed-rate mortgage at about 4 percent today. That’s a great deal.

But maybe you’ve noticed that adjustable-rate mortgages are even cheaper. You’ll find ARMs with rates as low as 2.64 percent to 2.96 percent, depending on the loan term..

The potential savings

Wow. That’s pretty tempting. Your savings could be big. Suppose you borrow $100,000. Here’s the comparison with a fixed-rate mortgage:

• 30-year fixed-rate mortgage. At 4.1 percent your monthly payment (not including taxes, fees, points, home insurance or mortgage insurance) would be about $483 a month.
• 5/1 hybrid adjustable-rate mortgage. At 2.96 percent, your payments (without taxes, fees and all the rest) would be about $419 a month for the first five years – saving $64 a month.

I used Zillow.com’s mortgage calculator for this estimate. Use your own numbers to estimate your own scenario.

Big risk

There’s a catch, of course. After those first five years, things change. ARMs are called adjustable for a reason: The size of your monthly payment can swell or shrink as interest rates rise and fall.

“Hybrid” ARMs, like this one, are like hybrid cars: You’ve got two systems in one vehicle. The ARM starts with a low fixed rate for a set period — five years in this case. When that ends, your cheap, dependable monthly payments are over. Now your payments can rise, fall or stay the same, depending on current mortgage rates.

A 5/1 hybrid ARM like the one in our example has a five-year fixed-rate period followed by an adjustable period in which the interest rate is recalculated, or “reset,” every year.

Here’s what AARP says about the risk:

Caps limit how much the rate can increase at each adjustment. But over time, the rate can climb significantly, making your payments much harder to afford. Some ARMs can rise as much as 6 percentage points during a 30-year term.

You can easily get into hot water. As The Wall Street Journal writes, about the current popularity of 1/1 ARMs among wealthy consumers:

Rates on a 1/1 ARM can rise by as much as six percentage points, based on most loan terms. A borrower who signs up for a 1/1 ARM at a 3.05 percent rate, which mortgage information website HSH.com cites as the average rate, could see the rate rise to a maximum of 9.05 percent during the life of the loan. With ARMs that have a one-month fixed-rate period, rates can jump by 10 or more percentage points over the life of the loan.

Today’s interest rates are low and may start rising soon. So it would be a mistake to get an ARM, betting you won’t have rate increases. The increases could wipe out any savings from your cheap, fixed-rate period.

So who’s the right customer for an ARM? It might be right for you if:

You’re not sticking around

If you plan to move before your fixed-rate period expires, you could buy a home at a very cheap price. Says Realtor.com, “Someone who has a payment that’s $100 less with an ARM can save that money and earn more off it in a higher-yielding investment.”

You can’t count on being able to sell your home to get out of an ARM, however. AARP’s primer on adjustable-rate mortgages, published in 2011, says:

But if the housing market in five years is anything like today’s market, you could have a very difficult time selling. And that means you’d be stuck with an ARM that resets to a higher rate and a higher monthly payment.

It’s also risky to assume you’ll be able to refinance out of your ARM when the payments reset. What if you can’t get a mortgage?

You’re rich

If you have the cash to easily pay off your mortgage when the rate starts climbing, you’re in good shape. But few of us can do that.

Wealthy borrowers are using 1/1 ARMs as part of a sophisticated strategy described by the Journal:

High-net-worth borrowers also are using these mortgages as leverage against their investments, says Frank Destra, managing director and head of UBS Mortgage. Because of their low rates, 1/1 ARMs could allow them to maintain a comfortable spread between the interest rate they’re paying out on their mortgage debt and the returns they are earning from their investment portfolio even when rates start to rise.

Not for amateurs

ARM contracts are complex beasts. Mind-numbing provisions lay out the rules on how much your payments can rise or fall, how often and whether there’s a limit or cap on the increases.

Don’t make this decision without help. While ARMs no longer have the kind of sketchy features that made them infamous in the housing boom — negative amortization ARMs that could grow your debt larger, for example, or exploding-rate ARMs with super-high-rate increases — they’re still risky investments for all but the most experienced consumers.

Find a trustworthy adviser. That’s not a mortgage lender or broker who’s trying to sell you a mortgage, or an adviser charging big fees, or any fees before delivering a service.

You’ll find free or cheap advice from these nonprofit agencies:

• The National Foundation for Credit Counseling connects you to a nonprofit certified housing counselor near you.
• Find a nonprofit HUD-approved housing counselor in your area by clicking your state on this map.

Learn more about ARMs from the Federal Reserve’s Consumer Handbook on Adjustable-Rate Mortgages. This MyFICO mortgage calculator lets you compare adjustable and fixed-rate mortgages.

Have you had a good or bad experience with an ARM? Share your story below or on our Facebook page.