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Embracing ARMs: Low rates make them more attractive

By   |  Posted in First-Time Homebuyers

Adjustable-rate mortgages (ARMs) lost their luster a few years ago when some of the more creative varieties turned out to be toxic for borrowers. But today's more traditional ARMs have a greater appeal, making these loans relatively more popular than they have been in recent memory.

Indeed, ARMs are "clearly making a comeback," says Leif Thomsen, CEO of Mortgage Master, an independent mortgage lender in Walpole, Mass.

The latest figures from the Mortgage Bankers Association support Thomsen's assertion. The MBA found that ARMs accounted for about 6.1 percent of all mortgages written in the U.S. in April 2011, compared to just 1.50 percent in April 2009. That said, the current figures are still a far cry from when ARMs represented 28.6 percent of the market in April 2006.

ARMs offer lower mortgage rates

The chief attraction of an ARM is the lower mortgage rates they offer (compared to 30-year loans) during their initial fixed-rate period.

The spread between an ARM rate and a fixed-rate loan varies depending on the type of loan product and fluctuates depending on the direction of certain market interest rates. As Thomsen explains, the savings over the initial fixed-rate term of an ARM can be substantial.

Here's an example: the monthly payment on a $350,000 loan with a fixed interest rate of 4.75 percent is $1,825. The payment on the same loan amount with a 5/1 ARM rate of 3.125 percent is $1,500, a savings of $325 a month. That adds up to $21,360 in savings over the first five years of that 5/1 hybrid ARM (on which the rate is fixed for five years and then adjusts yearly).

"If the spread is bigger than usual, why not take it?" Thomsen says.

Prepare for your ARM's rate increase

The catch with an ARM is that the payment can jump significantly when the initial fixed-rate period ends, eventually shrinking or zeroing out the savings ARMs can provide. Still, Thomsen suggests that shouldn't be a problem for many borrowers.

"If you're a single retired person on a fixed income, you should have a fixed rate," he says. "But normally, people get raises every year and can therefore afford a jump maybe five or seven years down the road or will have moved or refinanced before then."

Many experts advise ARM borrowers to bank the money they're saving each month during the initial fixed-rate portion of their ARM so they're better prepared for when their rate adjusts.

A 7/1 or 10/1 ARM, which has a longer period prior to any adjustments, can cushion the risk, though the interest rate savings will be smaller. Some lenders also offer a 3/1 or 3/3 ARM, among other combinations.

The 5/1 and 7/1 ARMs tend to be the "sweet spot," suggests Steve Majerus, regional vice president at First California Mortgage Co., a mortgage company in Danville, Calif.

"You can make the argument that since the average person moves once every five to seven years, the premium you pay for the stable 30-year fixed rate is pretty high," he says. "The 3/1, although it's attractive in terms of rate, still makes most consumers a little nervous. That time horizon is pretty short."

ARMs still pose risks

Borrowers who obtained a traditional ARM six, seven or eight years ago may have captured considerable additional savings as market rates have remained low for an extended period of time. That doesn't mean low mortgage rates will continue or the risk is nil, according to Ginny Ferguson, president of Heritage Valley Mortgage in Pleasanton, Calif. Sooner or later, she explains, the economy will strengthen and interest rates will start to move up.

That prospect has convinced Ferguson's clients, who she characterizes as financially conservative, experienced homeowners, to stick with fixed-rate loans.

"They don't want to think about, five years from now or seven years from now, having their rate change," she says. "They want that security of knowing what their payment is going to be, so they don't have to worry about it."

ARM options

If you're in the market for an ARM, you'll want to shop around and ask several lenders which configurations they can offer you. Almost all of the lenders in the Freddie Mac survey said they offered a 5/1 ARM, but only about 70 percent offered a 3/1 ARM, and even fewer offered a 7/1 or 10/1 ARM. Only 9 percent offered a 3/3 ARM, which adjusts once every three years.

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