The Risks of Adjustable Rate Mortgages

Confounding most predictions, mortgage rates have remained unusually low this year, begging a question: is an adjustable-rate mortgage worth the risk?

It can be, but it's likely that many borrowers focus on the wrong issue, looking at the way lower interest rates on ARMs (as opposed to fixed-rate loans) reduce monthly payments. Currently, a one-year ARM charges 2.876%, a 30-year fixed-rate loan 4.313%.

A lower payment obviously means more money in your pocket for other things. But if that's what matters to you, consider it a red flag. The ARM rate will start out lower than the fixed-rate loan, but could go higher when the annual adjustments start after one, three, five or seven years. At some point, you could pay more each month than you would if you'd taken out a fixed loan. That means if you think the monthly payment on a fixed loan would be a stretch, be very wary of taking out an ARM for the same amount.

Why, then, would you even consider an ARM? In a nutshell, not to reduce monthly payments but to reduce your overall interest charges — assuming everything works in your favor.

Consider some numbers produced by Jack M. Guttentag, emeritus professor of finance at the Wharton School. On a $300,000 loan, he figured a 30-year fixed mortgage would charge 4%, for a monthly payment of $1,432. A five-year ARM would start at $2.635%, for $1,205 a month.

After five years, the ARM rate would be reset every 12 months, based on a formula using prevailing rates, with a "cap" limiting the annual changes — typically 2 percentage points for each adjustment, up or down. Assuming the rate went up the maximum allowed, the five-year ARM would still be cheaper than the fixed loan for nine years. It would take that long for the rising payments on the ARM to wipe out the savings enjoyed in the first five years. After the nine-year breakeven point, the total cost of the ARM would be higher than for the fixed loan.

Note that in year six, the ARM would charge about 4.6%, while the borrower would have continued paying just 4% on the fixed loan. In year seven, the ARM could charge 6.6%. So although the total costs of the ARM are still lower through these years, the monthly payment would be considerably higher than on the fixed mortgage.

Of course, the borrower could get lucky, with smaller rate hikes. Conceivably, rates could even go down.
But if that happened, the savings would be gravy. Unless you have a crystal ball, the prudent move is to assume the rate will go up the maximum allowed.

All this demonstrates that an ARM is a safe bet only if you can afford the maximum payments it could charge, and that overall savings are certain only if you expect to pay off the mortgage before the breakeven point — by selling the home, for instance. If you expect to have the loan longer than that, savings are a gamble. (Find the breakeven point with the ARM vs. Fixed Rate Mortgage Calculator).

To improve your odds of coming out ahead, the monthly savings from the ARM should be reinvested, not spent. That "extra" cash could be used as extra principal payments to reduce the mortgage balance, thus reducing the payments after subsequent adjustments. Or it could be invested in stocks, bonds or mutual funds — anything that looks promising.

But if you're considering an ARM because the lower initial payments will make it easier to put food on the table or make your car payment, better reassess. In this case, the key issue is not whether to get an ARM instead of a fixed loan, it's whether you'd be wiser to buy a cheaper home.

By the Tracy Tidwell Team at ERA Henley Real Estate in Conway, AR
http://www.tracytidwell.com
Tracy: 501-472-4709   ERA: 501-327-6731