Worth a Look: The 5-Year ARM

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Five-year adjustable-rate mortgages look like a terrific deal, charging nearly a full percentage point less than the 30-year fixed-rate mortgage. Any ARM presents risks, but for some homeowners, the five-year deal is worth considering.

The latest BankingMyWay survey shows that the average five-year ARM rate has fallen slightly in the past week, to 3.583%, while the 30-year fixed rate has gone up a tad to 4.576%.

On a $300,000 loan, that ARM could cost $10,354 less than the fixed loan during the first five years. Also, the ARM would enable a homebuyer to pay down the loan balance a bit faster, since the lower rate would allow more of each month’s payment to go toward paying the principal.

With the $300,000 loan, you could build up an extra $4,314 in equity by choosing the ARM for a total five-year savings of $14,668. (Use the ARM vs. Fixed Rate Mortgage Calculator to check your own figures.)

That sounds fine so far, but what about the risk from future rate adjustments? With the fixed loan, the rate would stay the same for 30 years. The typical five-year ARM resets every 12 months after the first five years and could someday charge more than you could get on today’s fixed loan.

That risk would depend on the exact loan provisions, however, but there’s still a good chance that even in the worst case it would take several more years for higher ARM rates to wipe out the savings produced by the ARM in the first five years.

Suppose, for example, that after the first five years, the ARM rate jumped two percentage points, to 5.583%. For the $300,000 loan, you’d pay $135 a month more than if you’d taken out the fixed mortgage. It would take more than 100 months for that extra payment to offset the nearly $15,000 the ARM has saved you over the first five years.

Of course, the ARM rate might go higher than 5.583% after year six or seven, or some time later. But the ARM is certain to save money in five years, and very likely to save money over seven or eight years, if not longer.

By then, you might be ready to sell the home. Or your income might have risen enough to easily cover a higher payment. Or there might be a chance to refinance to a lower fixed rate. Keep in mind, though, that if ARM rates rise substantially, fixed rates will probably rise considerably as well. It would be very risky to assume that in five, six or seven years you could get a fixed rate as low as you can get today.

If you expect to stay in a home for 10, 20 or 30 years, the fixed rate is probably the best option. But if you plan to own for less than 10 years and can afford a bit of risk, the five-year ARM is worth a look. Use the search tool to locate some good candidates.

And be sure to nail down the details. Find out how often the rate will reset after the first five years. Ask about annual and lifetime caps on rate increases. Typically, those are 2 percentage points in any one reset, 6 points over the life of the loan.

Also ask how the resets are figured. They will typically add a “margin” to an index, or measure of prevailing interest rates. Many ARMs add a 2.75-percentage point margin to the rate paid by U.S. Treasury securities with one year to maturity.

—For the best rates on loans, bank accounts and credit cards, enter your ZIP code at BankingMyWay.com.

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