Why an ARM May Beat a Fixed-Rate Mortgage

CHICAGO ( MarketWatch ) — Don't be so sure that a 30-year fixed-rate mortgage is the best home loan for your needs. For some borrowers, it may make more sense to consider an adjustable-rate mortgage instead.

Scarred by the housing crisis and fears of ARMs resetting to unaffordable payments, borrowers have been reluctant to assume much risk in their mortgage loans lately, with many of them opting for the predictable 30-year fixed-rate mortgage.

For a time, taking that extra security didn't cost much, since the adjustable rates weren't that much lower than the fixed-rate options. But today, the rate spread between the 30-year fixed-rate mortgage and the 5-year ARM has widened to historic levels, some say.

As rates on 30-year fixed-rate mortgages began increasing in October, "ARMs have not moved nearly as much," said Leif Thomsen, CEO of Mortgage Master Inc., a mortgage lender based in Walpole, Mass.

Assuming a $300,000 loan amount, a 30-year fixed-rate mortgage at 5.13% means a monthly payment of $1,634, said Keith Gumbinger, vice president of HSH Associates, a publisher of consumer loan information. Interest paid after five years: $74,053.

Compare that to a 5/1 hybrid adjustable-rate mortgage at 3.83%. For the first five years, the monthly payment would be $1,403, and you'd pay $54,771 in interest over those five years, Gumbinger said.

So, for a borrower who plans on moving within five years anyway, they'd save as much as $19,283 by financing with an ARM. For the examples, Gumbinger used HSH's four-day cumulative rate averages from Feb. 7 through 10.

"It's certainly worth saying that many borrowers overpay or overbuy the security that they need," Gumbinger said. But "unless you can say with certainty where you will be in five years, you will have a little level of discomfort about what could occur" if you accept an ARM, he said.

That's because — in the case of the 5-year ARM — the rate will reset at month 61, adjusting to market conditions. If, say, that ARM reset three percentage points higher (a hypothetical, since it's unknown by how much it would reset) that would could mean a new monthly payment about $480 higher, Gumbinger said.

But if the savings from taking the 5-year ARM over the 30-year fixed-rate mortgage is banked and used for when the rate resets (again assuming that three percentage point hypothetical increase) you'd feel no budgetary stress from the payment increase for about 40 months, he said.

And if your time frame for living in the home is longer than five years but less than seven, you might consider a 7-year ARM, which would also offer savings over a 30-year fixed-rate. There are also 10-year ARMs, but their rates are often close to those on 30-year fixed-rates.

Why the spreads are high

Blame inflation expectations for causing the wide spread between fixed and adjustable rates, said Dan Green, loan officer with Waterstone Mortgage, in Cincinnati.

"In the near term, the markets expect low levels of inflation. But over the medium to long-term, they expect high inflation," he said. From the investor's perspective, rates have to be higher on a 30-year product because the dollars they'll collect at the end of the term will be worth less than those collected at the start, he said.

With an ARM, the rate is fixed for a much shorter amount of time so the initial mortgage rates can be priced lower. Instead of the banks assuming the inflation risk, the borrower does because it's unknown what they'll be paying when the mortgage adjusts at the end of the fixed-rate period.

"Longer-term interest rates respond more to the potential for inflation," Gumbinger said. "The opposite end of that coin: Short-term interest rates respond much more to what the Federal Reserve does."

More choose ARMs

While the volume of adjustable-rate mortgages originated has decreased in recent years, the share of ARMs is slowly rising.

ARMs finance 7% of new home-purchase loans today, down from a peak share of 40% of the market, Frank Nothaft, vice president and chief economist of Freddie Mac said in a news release in January that detailed the results of Freddie's annual ARM survey. But today's share of ARMs are up from the 3% share reported in early 2009, he said.

"We are expecting ARMs to gradually gain back some favor with mortgage borrowers rising to an average 9% share of the home-purchase market in 2011," Nothaft said in the release.

Green said he doesn't usually recommend an ARM unless it's clear that the borrower will be out of the home before it adjusts. An example would be a young couple who is living in a condo unit that they will outgrow when they start a family. Another example Thomsen gave: A couple near retirement who have savings stashed away and plan on financing their home for a short time until they pay their mortgage off altogether.

Yet even if their situation is a perfectly applicable one for an ARM product, some borrowers are opting for the 30-year fixed-rate mortgage anyway, fearful of what will happen if their plans don't work out the way they envision.

"You can talk about the math all day long, but in the end it has to be the right fit for the borrower," Green said.

Be realistic about your tolerance for risk, Thomsen said. If the majority of your assets are in money market accounts and certificates of deposit, "you should have a fixed-rate because you have no tolerance for risk," Thomsen said.

And if you do choose an adjustable mortgage, prepare in advance for the end of the fixed-rate period by socking money away in order to comfortably handle a possible increase in monthly payment when it hits. That, or use the savings toward paying down the principal so when the mortgage resets you have a smaller amount to pay interest on.