Despite Rate Drop, ARMs Still Risky


Interest rates on adjustable-rate mortgages (ARMs) have declined over the past few weeks, just as rates on fixed-rate mortgages (FRMs) have trended upwards. But despite this shift, you still might want to think twice before applying for an ARM.

In mid-January, interest rates on five-year ARMs averaged 0.8 percentage points higher than the rates offered on 30-year FRMs, according to's Rate Index. But since then, the gap has all but disappeared. Interest rates on five-year ARMs have dropped to 5.38% while rates on 30-year FRMs have risen to 5.36% -- a difference of just 0.02 percentage points.

The drop in the average rate on ARMs has caused a stir in activity among such mortgages, but homebuyers remain wary -- ARMs still account for only 2.3% of total mortgage applications, according to the Mortgage Bankers Association. The reluctance to embrace ARMs is well-founded: despite currently low interest rates, there are still significant long-term risks to applying for an ARM.

On a $200,000 mortgage, a five-year ARM with an initial rate of 5.38% might cost you $85,000 more in interest over the life of the loan as compared to a 30-year FRM at 5.36%. And that's provided your rate only adjusts upwards a maximum of 0.25% each year after the first five years of the initial rate.

If rates rise faster than that -- and some analysts predict that double-digit interest rates could go hand-in-hand with a recovering economy -- the extra cost of that ARM could easily reach $150,000 or more in added interest charges. To see for yourself, check out's ARM vs. Fixed mortgage calculator.

So why would people consider applying for an ARM? Many experts recommend comparing the APR, or annual percentage rate, when shopping for mortgages. And ARMs often have the lowest APRs. With a FRM, APRs reflects the extra closing costs on a loan, so they often appear higher than the listed interest rate. For an ARM, however, the APR has to account for potential rate adjustments. Rates are at historic lows right now, and so rates on most ARMs would actually fall if they were scheduled to adjust. This allows lenders to publish really attractive APRs.

For instance, residents of New York can apply for a five-year ARM from Citibank (Stock Quote: C) with a listed interest rate of 5.875% but an APR of just 5.011%. Similarly, JPMorgan Chase (Stock Quote: JPM) and HSBC (Stock Quote: HBC) offer five-year ARMs with rates of 6.25% and 5.5%, and APRs of 5.0% and 4.877%, respectively.

So even if you are attracted to a fantastic APR on an ARM, just remember that a good rate today doesn't mean good long-term savings. As a result, many homeowners are better off keeping the ARMs off the table and sticking with the guaranteed rates on FRMs.

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