Adjustable Rate Mortgages: When Are ARMs a Good Deal?

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(Image by Sean Dreilinger)

Can oft-maligned adjustable-rate mortgages actually contribute to your household’s bottom line? The short answer — excuse the pun — is “most definitely.”

When it comes to types of mortgage loans, ARMs aren’t too popular these days. A recent study by Freddie Mac notes that 95% of all mortgage refinances include fixed rate mortgages —very different from the days of the sub-prime debacle.

The Freddie Mac report has another interesting tidbit: 58% of adjustable rate mortgage holders switched from an ARM to a fixed-rate mortgage in the fourth quarter of 2012. That suggests homeowners are spooked by ARMs (understandable with the sub-prime mortgage mess), but if this is the case, that outlook may be premature.

How so? In some instances, going with an adjustable rate mortgage (ARM) makes a great deal of sense for homeowners.

Let’s examine a few scenarios where an adjustable rate mortgage works:

1. Short-Term Financial Gain. If you’re in the military, in sales, or are otherwise inclined to stay in your home for only five years or less, an ARM can actually help you save money. In the first few years of an adjustable-rate mortgage, interest rates are usually lower than fixed-rate loans (some real estate observers call these “teaser rates” as they tend to rise after five years in an ARM). In the Freddie Mac report, chief economist Frank Nothaft makes this very same point:

“For borrowers who plan to remain in their current home for only a few years, the hybrid ARM allows for an even greater interest-rate savings,” says Nothaft. In the fourth quarter, “the initial interest rate on a 5/1 hybrid ARM was about 1.1 percentage points lower than on a 30-year fixed-rate loan.”

According to Freddie Mac’s own figures, as of May 10, 2012, 30-year fixed mortgage rates are at 3.83%, while a five-year ARM interest rate is 1.02 basis points lower, at 2.81%. That can translate into savings of a few hundred dollars each month in mortgage payments, and less interest paid over that five-year period than with a fixed mortgage.

2. For Retirement Purposes. ARMs can be a decent option over fixed rate mortgages for homeowners nearing retirement. Here’s why: If you’re only several years away from retirement, and plan to sell your home once you retire, you can refinance your fixed-rate mortgage into an ARM. You’ll get a lower interest rate, and lower mortgage payments, which you can sock away for your golden years. This is only a good idea if you plan on selling your home and moving elsewhere for retirement, of course.

3. Get More Value Out 0f Your Larger Home. This one might be tricky, and should only be put into play after a thorough discussion with a financial planner or bank loan officer, but it does work.

With less cash needed for interest payments, an ARM can help you qualify for a larger home – a big attraction to a large family that needs the extra room. Homeowners who adopt this strategy simply take out a one-year ARM loan, and refinance each year back into another one-year ARM. That enables the homeowner to pay the lowest possible mortgage, year-after-year, for a larger home. The trick is to keep refinancing costs low, and that’s where a good advisor or loan officer can come in handy.

Nobody is saying ARMs don’t come without some risk. But if used adroitly, an ARM can actually provide a financial boost for homeowners in the right situation. Like any other move in life, getting creative with a home loan – after thorough review of all the options– can really pay off in the end. Be sure to check out the Credit Sesame Mortgage Payment Calculator.

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