Is the Adjustable-Rate Mortgage Dead?


Take a glance at the latest mortgage survey and you’ll see that rates on one-year adjustable-rate loans have gone up, while rates on 30-year fixed-rate deals are cheaper, with both hovering around 5%.

It raises a question: Are ARMs suitable for anyone these days?

Only a small subset of borrowers appears likely to benefit from adjustable loans in today’s market — people anticipating a financial windfall in the next few years. According to the Mortgage Bankers Association, adjustable-rate loans account for just 5.5% of recent mortgage applications.

The popularity of ARMs waxes and wanes as market conditions change. There are two chief reasons to opt for an ARM, and neither applies today.

First, ARMs often start with a low initial rate that means smaller monthly payments than on a fixed-rate loan of the same size, at least for the first year or two. If the ARM starts out at 3.5% and the fixed loan at 5.5%, the savings can offset the risk that the ARM’s payments could rise over time. Also, an ARM’s low starting payment can make it easier for the borrower to qualify for the loan, or enable the borrower to get a bigger loan.

Unfortunately, ARMs currently offer no upfront savings, while they still pose the risk of rates someday rising above the 5% you can lock in with a fixed-rate deal. That makes an ARM unappealing.

Second, an ARM can be an acceptable bet if one believes interest rates will stay low for a number of years, or fall lower. That will keep the ARM rate low once annual adjustments begin.

But today’s rates are so low the odds favor them going up over time, not down.

With neither of the basic ARM benefits applicable today, the only remaining benefit is found in an often-overlooked feature of ARM adjustments. With each adjustment, the new payment is figured by applying the new interest rate to the remaining principal or outstanding debt. That means the borrower can reduce the payment by making extra principal payments.

In contrast, extra principal payments on a fixed-rate loan allow the borrower to pay off the loan sooner, reducing interest costs over the loan’s life. But the required monthly payment stays the same.

The Mortgage Loan Calculator shows you’d pay $1,610 a month on a 30-year fixed loan of $300,000 charging 5%. An ARM for the same amount at that rate would charge the same.

Now suppose that two years after taking out the loan you came up with $100,000 from selling another property or investment, or from an inheritance.

Put the $100,000 into the fixed-rate loan and the payment will remain $1,610 a month, though the loan will be paid off 13 years ahead of schedule, saving nearly $150,000 in interest charges.

But if you put that sum into the ARM, the payment would fall to just $1,026, assuming the rate remained 5%. After the first five years, you’d still owe $275,487 on the original loan. Reducing that by $100,000 and figuring a new payment for the 25 remaining years slashes the payment.

At this point you could choose between paying only $1,025 for the next 25 years and continuing to pay $1,610 in order to pay the loan off 13 years early. Either way, the $100,000 principal payment will save you a fortune in interest costs. But if you had the ARM, you’d have the option of making a smaller payment if and when you wanted to.

Prepayments work the same way with three-, five- and seven-year ARMs, but your payment will not fall until the initial fixed period ends.

If the ARM approach appeals to you, use the shopping tool to investigate all types of ARMs for the best deals. Wells Fargo (Stock Quote: WFC), for example, has a five-year ARM starting at just 3.625%, and JPMorgan Chase (Stock Quote: JPM) has one at 3.25%.

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