Makin' Money

A call to ARMs?

Chris Farrell Mar 21, 2011

Adjustable rate mortgages are back. No, not the toxic variety with deceptive teaser rates. Home buyers are turning to low-rate plain-vanilla ARMs, according to the New York Times.

It isn’t surprising considering that ARMs are popular once again. The rates on well-designed ARMs aredown over the past few years. They didn’t go up as many feared.

Still, I wonder if homeowners are giving up too much long-term financial security for upfront savings?

Yes, the story makes clear that borrowers are favoring so-called hybrid ARMs. The two most popular hybrids are the 5/1 and the 7/1. The interest rate is stable for 5 years in a 5/1 and it adjusts annually after that period of time. The 7/1 is fixed for 7 years and then it adjusts. The idea is it’s a good product since many people move within a 5 to 7 year period. It’s a good product.

Yet the interest rate on these ARMs from today’s baseline can go as high as 10% or more once the adjustment period starts. Thing is, plans change. Who knows what we’ll be doing 5 to 7 years from now? You may want to stay in the house. You may not be able to sell it. Its possible that interest rates will be much higher in a couple of years, too–or not.

The built-in advantage of a fixed rate mortgage–currently at a natinal average of 4.75%–is that it doesn’t matter if your plans change or interest rates are higher. You can always refinance if rates go lower.

There aren’t very many simple, easy financial hedges against uncertainty for individuals. The fixed-rate mortgage stands out for that reason. An ARM is a riskier loan by definition. I would think long and hard before giving up an insurance policy against the risk of higher interest rates and changing plans.

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