ARMs Suit Some, but What About You?

At a time when 30-year fixed-rate mortgages are hovering just above historic lows, does it make sense to get an adjustable-rate mortgage? A growing number of people seem to think so. An estimated 10% of borrowers, up from 3% in 2009, will opt for an ARM this year, according to a recent Freddie Mac survey of 112 lenders nationwide.

Should you be among them? The answer, it turns out, depends greatly on your specific situation and your tolerance for risk. In some cases, ARMs are certainly worth a look.

Risk and Reward

If you've had an ARM before and you understand the product, there can be a lot of upside to going with a variable rate, especially in the current market, according to Pat Peavley, executive vice president of McLean Mortgage Corp. in McLean, Va.

"As rates on fixed-rate loans continue to rise, ARMs will become more popular due to the lower initial rate," Peavley says. "Today, the 30-year fixed rate is around 4.75%, while a 5/1 ARM is still about 3.5%. That's a significant savings during the first five years of the loan."

ARMs aren't for everyone, though. "Many borrowers pay more for certainty because they don't expect their income to rise or they plan to stay in the home a very long time," Peavley says.

The real reason most borrowers shy away from an ARM is their own risk tolerance, says Michael Moskowitz, president of Equity Now, a direct mortgage lender headquartered in New York City.

"An ARM would save most of our customers money, but only about 15% of the loans we fund are ARMs because not everyone is comfortable with the risk," Moskowitz says. "If they can't sleep because they're worried about interest rates, it's not for them."

Moving Plans Matter

Even if a borrower has a relatively low risk tolerance, they may want to look at an ARM if they plan to move soon. These days, few borrowers stay in their houses for the 30 years it takes to pay off a fixed mortgage. If borrowers choose a 30-year fixed mortgage and end up selling well before the final payment, they've probably lost money on the deal, says Dan Green, a loan officer with Waterstone Mortgage in Cincinnati.

"With a 30-year fixed mortgage, the borrower pays a premium for stability," Green says. "An ARM allows the bank to shift some of the risk of rising interest rates on to the borrower, but it also means the borrower will pay less for the loan."

In essence, borrowers who know they're going to move soon are making a short-term bet that the lender will undercharge them during the period they occupy the home. However, that's where things get tricky, according to Green.

"Moving soon means within the next two years or less," Green says. "Choosing an ARM because you plan to move in 10 years doesn't make a lot of sense because you can't predict that far ahead to determine if it's a good deal."

Not that a borrower can necessarily predict the future two years out, either. However, Green says, there are plenty of situations where a borrower knows they won't be in the same house in 18 to 24 months.

"If you're starting a family and you know you'll need something bigger, an ARM makes sense for that interim period before you buy," says Green. "Or, if you know for sure that you'll be moving because of work within that time span, it's a good idea to consider an ARM."

The Downsides

Make no mistake, ARMs have a big potential downside because the rates can jump, leaving the borrower on the hook for more than if they had gone with a traditional product. "That risk is always there," says Moskowitz. "However, it's a risk that you can and should understand before you take the loan."

There are also risks that are not necessarily inherent to the ARM. For instance, borrowers who choose ARMs in accordance with a specific plan for the next few years always run the risk that their predictions could be wrong.

"You could lose your job, get sick or be unable to move," says Moskowitz. "That's a risk, but that's also just life."

Another risk is using the ARM to buy more house than you can really afford. In the past, ARMs were sometimes used to qualify questionable borrowers because the initial monthly payments were lower than those associated with a 30-year product. Theoretically, it looked like borrowers could afford the house, but really they could only afford the initial payments. Thankfully, that's changing, says Sharron Eastman, president of Big Horizon Mortgage in Kennebunk, Maine.

"Now, most lenders require that a borrower qualify at 2% over the start rate, which eliminates the old practice of using the ARM to qualify for more house than you can afford," Eastman says.