NEW YORK (MainStreet) – Adjustable-rate mortgages, reviled a couple years ago for quickly hiking their rates to unsustainable levels that lead many homeowners to foreclose during the financial crisis, are staging a bit of a comeback. The Mortgage Bankers Association says ARMs accounted for about 6% of new mortgages written in April, up from just 1.5% in April 2009.
The recent figures are still far below the 28% high in April 2006, but any rebound is notable given that fixed-rate loans, which are far less risky to borrowers over the long term, are a terrific deal with rates currently near record lows.
If you’re shopping for a mortgage, is an ARM worth considering? Yes, assuming you fall into one of two categories: you’ll need the new loan for only a few years or you expect healthy pay raises. Those conditions neutralize the danger from any increase in monthly payments after your ARM resets to a new interest rate in the future while allowing you to enjoy lower payments in the meantime.
Currently, five-year ARMs average about 3.5% interest for the first 60 months before beginning the cycle of annual resets, which will be guided by an “index” that will reflect prevailing rates in the future. The standard 30-year fixed-rate mortgage averages nearly 4.9%, according to the BankingMyWay.com survey.
For every $100,000 borrowed, the ARM would charge $449 a month and the fixed loan would charge $531, according to the BankingMyWay ARM vs. Fixed Rate Mortgage Calculator. On a $300,000 loan, you’d save nearly $15,000 over the first five years with an ARM.
After that, your interest rate would reset, and if rates go up you could well end up with a payment larger than on the fixed loan. Since rates are unusually low now, they’re more likely to go up than down over the next five years. But, of course, no one knows for sure.
But even if rates did rise, it might take an additional four or five years for your larger ARM payment to wipe out the savings you’d enjoyed in the first five years, so it could take nine or 10 years before the ARM became a money loser. If you move before then, the ARM would be a good deal. And if your income grew steadily, a higher ARM payment might not be a big problem.
So is this why more people are taking out ARMs this year than last? Certainly, some borrowers see it this way. Others may be getting ARMs because the lower initial payment makes it easier to qualify for a loan, or because the gap between rates on ARMs and fixed loans is wider than it was a year ago.
ARMs have been around for decades but fell into disrepute when the housing bubble burst several years ago. In the run-up to that crisis, many lenders had offered exotic forms of ARMs that produced dramatic payment increases in their first resets, and many lenders had issued ARMs to borrowers who really couldn’t afford the bigger payments. Today, lending standards are much stricter and the current crop of ARMs is not so hazardous.
Still, borrowers should carefully weigh three factors when it comes to future payments:
The Index. This is the guide used to determine future rates. Lenders choose from a variety of indexes, from U.S. Treasury securities with one year to maturity to the London Interbank Offered Rate. Study the one your lender uses to see how large its up and down swings are over time.
The Margin. This is a number of percentage points added to the index to set the ARM’s new rate. A typical margin is 2.75 points. The smaller the margin the better.
The Caps. Many ARMs limit annual rate changes, up or down, to two percentage points, while placing a ceiling on the rate over the loan’s life. If you started at 3.5% with a 2% annual cap and 6% lifetime cap, the rate could not go higher than 5.5% on the first reset and could never exceed 9.5%.
If you do get an ARM, think about putting your monthly savings aside to help offset any future rate increase. If you used the savings for extra principal payments on the mortgage, you’d reduce the principal, or remaining debt, at the time of your first reset. That would minimize your payment when the loan was recalculated with the new interest rate, remaining balance and years left to pay off the loan.