You don't hear a lot about adjustable-rate mortgages (ARMs) these days. That's too bad, because they're still a good choice for many homebuyers, believe it or not.
ARMs can be a very smart choice for homebuyers who are not planning to stay in the home more than a few years. Think about it -- if you're planning to sell the home within seven years, as many homeowners do, what difference does it make if you have a seven-year ARM? Why not take advantage of the lower rate and pocket the difference?
They're also a popular choice for savvy investors who keep a careful eye on how they allocate their money among various investments, but if you're in that group, you probably don't need to be reading this article.
ARMs then and now
Unlike fixed-rate mortgages, ARMs start out with a certain mortgage rate for the first few years, then "reset" to a new rate after that period is over. The new rate is based on a formula tied to the prevailing rates at that time. The initial rates are lower than on fixed-rate mortgages because lenders are locking the rate in for a relatively short time, usually five to seven years, compared to 30 on a typical fixed-rate mortgage.
ARMs got a bad reputation during the housing bubble and subsequent crash, when they got a reputation as "exotic" mortgages that enabled people to buy more home than they could afford and got them into trouble when the loan reset and their monthly payments increased, sometimes dramatically.
What got lost in the turmoil was that the problem wasn't so much with ARMs per se but with all the bells and whistles that got loaded onto them. Things like balloon payments, steep rate increases after the initial period, interest-only loans, negative amortization and other then-popular features created situations where many borrowers didn't understand just what they were getting into and easily ran into financial difficulty.
A standard type of loan
Here's the thing: ARMs are actually a very standard type of loan. In fact, they're the most common type of mortgage in countries such as Canada and the U.K., where they tend to be referred to as "variable-rate mortgages."
Most of the "exotic" features associated with ARMs during the housing bubble have pretty much disappeared, taking the excess risk along with them. New consumer protections enacted since the crash also require that potential changes in interest rates and monthly payments must be clearly disclosed before the loan is closed, so you're much less likely to be surprised when the loan resets.
ARMs currently make up only about 5 percent of all new mortgages in the United States, according to the Mortgage Bankers Association, down from 60-70 percent in the 1990s. That's largely due to the fallout from the housing bubble, but also because interest rates on fixed-rate mortgages are so low that many borrowers figure they might as well lock in a rate for the long haul.
Advantages for short-term homeowners
Even so, if you're confident that you'll only stay in a home for a few years, why pay more than you have to? Currently, initial interest rates on 5/1 ARMs are running about 0.8 percentage points below that of a comparable 30-year fixed-rate mortgage. On a $250,000 mortgage, that's a difference of about $110 a month, or about 10 percent less, depending on your actual numbers. That's a fairly hefty savings.
If you're not planning to stay in a home longer than 10 years, you can probably find an ARM that fits your plans. Most lenders offer ARMs in terms such as 3/1, 5/1, 7/1 and 10/1, so you can match the loan type to however long you plan to live in the home.
Rate increase is limited
Even if prevailing mortgage rates increase significantly between now and when the loan is due to reset, most ARMs these days are fairly limited in how fast the rate can rise. That means you're not likely to get socked immediately should you stay in the home longer than expected. However, you want to be sure you understand how the rate formula works in order to avoid loans with steep increases on the back end.
A basic ARM is as "standard" as any other type of mortgage loan. It just depends on what works best for your situation. Borrowers who plan on making a home their permanent residence may be better served with a fixed-rate mortgage, but if you plan to move up or relocate again within the next decade, you owe it to yourself to look into whether an ARM might be the better choice for you.
View the original story here: http://www.mortgageloan.com/rethinking-adjustable-rate-mortgages-9231