Adjustable Rate Mortgages: Why They Make Sense Again

Even with a potential double dip recession underway and fixed-rate mortgages boasting all-time low rates, some homebuyers are taking a shot at adjustable-rate mortgages (ARMs). While 30-year fixed-rate loans are hovering around the 4.5 to 4.75 percent interest mark, buyers who opt for 5/1 adjustable-rate products will enjoy rates as low as an astonishing 3.1 percent for the next five years.

"What we're seeing right now with five-year adjustable rate mortgages is interest rates that are shockingly low," explains Neil Merritt, senior director for Sherman Bridge Lending in Colleyville, Texas. "The low rates are bringing a number of buyers back into the adjustable rate market."
Unlike a typical adjustable rate loan, 5/1 ARMs lock in an interest rate lower than that of traditional 30-year fixed-rate products for five years. After 60 months of payments, the rate gets adjusted every six months for the remaining duration of the loan. Also available in one-, three-, five-, seven- and 10-year products, the 5/1 ARM is the most popular, since it offers a substantially lower interest rate than the seven- and 10-year products and also gives the homeowner a significant amount of time to enjoy the fixed rate.

"The 5/1 works best for people who are planning on moving within 60 months before the adjustable rate portion kicks in," says Merritt. "If they're doing a temporary work stint in one particular place, or they're in the military, or planning on expanding their family and moving to a bigger place, that's when a 5/1 ARM makes sense."

The catch, says Sue Pearlstein, managing partner for Statewide Funding in Kentfield, Calif., is that 5/1 ARMs can be tougher to get than 30-year fixed-rate products.

"As of July of this year, [5/1 ARM] consumers have to have a debt-to-income ratio that can support a loan with a 2 percent higher interest rate than the current 5/1 price," says Pearlstein. "That means that if the 5/1 rate is three percent, you have to prove that you can pay off a mortgage of the same value at a 5 percent interest rate in order to qualify."

Pearlstein adds that 5/1 ARMs can also come with steep prepayment penalties, and since rates are so low right now, consumers can pretty much bank on a significant rate hike once the fixed-rate period is over. Combine those potential problems with the fact that it's difficult to estimate how fast a home will sell -- many have stayed on the market for a year or more before changing owners -- and you've got several considerations to take into account before deciding if a 5/1 ARM is right for you.

"In the housing market, there's still a lot that's up in the air right now, so a lot of my clients are still moving out of ARM products and into 30-year fixed-rates," says Pearlstein. "Mentally knowing that you're not ever going to have your interest rate changed is comforting to a lot of people."

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