We’re enjoying the lowest mortgage rates ever, and the lowest of the low these days can be had with Adjustable Rate Mortgages, or ARMs. You can use Credit Sesame’s Mortgage Rate Marketplace to find the lowest mortgage rate arms you qualify for based upon your credit score and financial goals.
Yes, fixed-rate mortgage rates have dropped below 4% for the first time in history (an average 3.94% with an average 0.8 point for the week ending October 6, 2011, according to Freddie Mac). But ARM rates are even lower, with 5/1 ARMs averaging 2.96% this week, with an average 0.6 point.
It’s no wonder that ARMs are making a comeback. For better or worse, ARM sales in the past few years suffered mightily for their role in the housing boom and subsequent bust. Recently, however, borrowers, lured by sub-3% interest rates, are returning to ARMs, even though fixed mortgage rates are also at historic lows.
Is this just history repeating itself — or is now the time to give ARMs another look?
How risky are ARMs?
The ARMs being sold today are not the same as the riskiest ARMs of the past decade. Today’s ARMs are primarily of the “hybrid” or fixed-adjustable variety. That is, they have a fixed period, usually five, seven or ten years, and then they turn into an adjustable-rate mortgage that adjusts annually.
Make no mistake, even a fixed-adjustable mortgage rate is far riskier than a fixed rate — but they have nowhere near the payment shock risk of a negative amortization or interest-only loan.
Another major difference between the boom years and now is more restrictive lending standards. Stated income and no down payment policies are relics of the past. Your lender will not only want to see that you can afford the loan now, but also that you will be able to afford it in the future.
It seems that banks have certainly learned their lessons from the bust — but how about borrowers?
Why are borrowers returning to ARMs?
Borrowers have always been drawn to ARMs because they typically offer a significantly lower interest rate than comparable fixed-rate mortgages.
According to the most recent Freddie Mac rate survey, the most popular ARM, the 5/1 ARM, is available for 2.96% whereas a 30-year fixed could be had for 3.94%. That almost 1 percentage-point difference, also known as rate spread, could put thousands of dollars back in your pocket over the next five years.
While saving money today could be an improvement to your current finances, you also need to consider impact on your future finances. One risk that some borrowers might overlook is that when mortgage rates are historically low (like they are today), there is nowhere for mortgage rates to go but up. This means that there is a very strong likelihood that a 5/1 ARM taken out today will adjust to a higher, possibly much higher, interest rate when the five-year period is over.
How bad could it get?
The good thing about ARMs is that once the fixed-rate period is over, the interest rate can’t adjust up indefinitely. That is, you can’t start out with a 3% mortgage rate and five years from now face a rate of, say, 12%. Hybrid ARMs have a so-called rate cap structure, which includes an initial adjustment rate cap (often 5%) , another rate cap for subsequent adjustments (typically 2%) and a lifetime cap, which is usually 5%.
That means that even if the indexes on which mortgage rates are based (most commonly, the LIBOR) increase dramatically over the next five years, your mortgage loan rate cannot go up by more than five or six percentage points.
But given today’s historically low mortgage rates, the possibility that your mortgage rate could hit the lifetime cap is pretty real. As a result, all borrowers should consider the worst-case scenario. That means evaluating how a payment at the maximum mortgage rate would impact your finances. If you don’t think that you can make the worst-case payment, you really should avoid ARMs regardless of the initial savings. No amount of initial savings can offset putting yourself in the position of having a loan that you cannot afford in the future.
Who should consider an ARM?
ARMs have always been best suited for borrowers who expect to either sell their property or receive a substantial increase to their income prior to the expected rate adjustment.
The housing bust, however, taught us the valuable lesson that reality can deviate wildly from our expectations. In a choppy economy, it makes the most sense to factor into your expectations flat growth in both real estate values and income for the next five years.