NEW YORK (MainStreet) -- At BankingMyWay.com, we’ve been watching five-year ARMs for a couple of years, pointing out the appeal of being able to lock in a low rate for 60 months. Now the five-year deal is even more alluring than before, falling to a mouth-watering 2.737%, with some lenders offering 2.5% or less.
Not long ago, the rate was well over 3% -- great, but not this great. For context, consider that the 30-year fixed-rate mortgage averages just under 4%. Oddly, one- and five-year ARMs charge more than the five-year, which normally has a higher rate because the lender commits for longer. One-year ARMs go for an average of just over 3%, three-year ARMs for just under 2.9%.
Why would anyone get a one- or three-year loan, and face the risk of a higher rate after the initial term, when it’s possible to lock in for less for a full five years? If you’re at all interested in an adjustable-rate loan, the five-year deal is a no brainer.
As we’ve said before, the 30-year fixed-rate loan makes sense for anyone expecting to have the loan for the long term – 10, 20, 30 years. The odds are just too good that rates will rise over the next few years, so that a five-year ARM taken out today would adjust to something higher after 60 months – a level higher than the 30-year fixed charges today.
But for anyone with a relative short time horizon – five, seven, eight years – the five-year ARM looks terrific, as far as rates are concerned.
Still, there is another factor to consider: home prices. If rates do rise over the next five years, the ARM borrower will have three options: pay the ARM’s new higher rate after the adjustment, refinance to a different type of loan such as a 30-year fixed deal, or sell the property.
Unfortunately, the refinancing option, like sticking with the ARM, would undoubtedly mean shouldering bigger payments, since a rise in prevailing rates would likely affect all types of loans. That leaves selling as the escape hatch.
But what if you could not sell? If home prices went into another downturn, many homeowners will owe more than their homes are worth – a problem already faced by one in four homeowners with a mortgage. To sell an underwater home, the owner must come up with cash for the difference between the debt and sales proceeds.
What are the chances home prices could fall further, and not recover over the next five years? Clearly, no one knows for sure. But it is worth noting that the national average home price is now at the level of 2002, meaning people who bought back then have no gains at all. It’s even worse for people who bought in the middle of the last decade, as prices remain about 35% below their peak in 2006 – six years ago. So five more years of weak or falling home prices is not out of the question.
Who then is most likely to benefit from a five-year ARM?
One group is people who have owned their home long enough to have built up substantial equity. These folks can benefit by replacing an older, more expensive mortgage with a five-year ARM at a rock-bottom rate. If the rate does jump after five years, the payment may still be small enough to live with, or the long-term homeowner may have other resources to pay off the loan.
Another group is investors who know their market’s risks pretty well and plan to fix up the home to sell fairly quickly. They can hope the added value from their improvements would offset any dip in home values. These borrowers don’t have to worry about a rate increase if they won’t be around to face a reset in five years.
For these buyers and refinancers, the five-year ARM does look appealing. But it doesn’t make sense for anyone who would have serious trouble with the higher payments that could come in the first reset.
So, as with any mortgage, it is important to study the terms, especially the “caps” that limit annual rate increases.