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ARM offsets low mortgage rates with higher risk

Poonkulali Thangavelu

With interest rates on the uptick, adjustable-rate mortgages, or ARMs, appeal to more borrowers.

The 30-year fixed-rate mortgage bottomed out at 3.5 percent in December 2012, and since then it has climbed more than a full percentage point. It's too late to grab a fixed mortgage rate of less than 4 percent, but an ARM offers that possibility -- temporarily.

While the prospect of a lower interest rate, at least initially, is alluring, you should also consider other factors before making your choice.

How ARMs work

With an ARM, you get the benefit of a lower initial rate for a few years before the interest rate changes, typically going higher. For example, with a 5/1 ARM, the interest rate will adjust initially after five years and every year after that.

The extent to which your rate will change depends on the index to which the rate is tied, such as the one-year Treasury or the one-year Libor, plus a margin that the lender will add to the index's interest rate. Typically there is a lifetime cap on the interest rate, which is the highest amount that the rate can adjust to. Here's an explanation of ARM indexes.

Lower rate comes with risk

The choice between an ARM and a fixed-rate mortgage boils down to opting for the security of a fixed-rate mortgage at a higher interest rate, or taking an ARM's lower interest rate and accepting the risk that the rate will eventually rise.

Fixed vs ARM comparison, 2005-2015

Monthly principal and interest payments on a $200,000 mortgage beginning in March 2005. Rate on 30-year fixed is 5.625 percent. Rate on 5/1 ARM begins at 5 percent. After five years, the ARM rate adjusts annually at the one-year Libor rate plus 2.25 percent.

Source: Bankrate.com

Who typically gets an ARM?

In today's still low interest rate environment, a 30-year fixed-rate mortgage might still be the better long-term choice for most people. However, an ARM could be a good choice in some situations.

ARMs are often considered by two groups of borrowers, says Cheryl Nolda, president of Home Lending Solutions for RBS Citizens Financial Group of Providence, R.I.

  • Those who plan to sell their home within a few years (maybe because they expect to be relocated by their employer).
  • Those who expect interest rates to remain low enough so they can refinance before the initial fixed-rate period ends.

Then there are borrowers who expect their incomes to rise -- for example, doctors coming out of medical school who expect to grow their practices. These borrowers qualify for fixed-rate loans, but they might opt for ARMs as a financial planning tool.

A loan pitch for the rich niche

Joe Rogers, executive vice president with Wells Fargo Home Mortgage, says Wells has seen greater demand for ARMs from affluent customers who are risk-savvy. This is particularly the case with customers who take out jumbo loans.

There has been relatively less interest in ARMs from low- to moderate-income borrowers and first-time homebuyers. During the housing boom, some buyers used ARMs as a way to qualify for loans when they couldn't qualify for fixed-rate mortgages. "That doesn't happen anymore," Rogers says.

Rules say you must be able to repay

New regulations discourage the practice of using ARMs to stretch affordability. The Consumer Financial Protection Bureau's qualified mortgage regulations require that lenders consider a borrower's ability to repay. Lenders have to calculate whether borrowers can repay after interest rate adjustments on ARMs.

Michael Calhoun, president of the Center for Responsible Lending, says there is still a gap in the rules because the ability-to-repay rule applies only to so-called qualified mortgages. When a loan meets the criteria to be deemed a qualified mortgage, the lender is protected from certain types of lawsuits.

"The non-qualified mortgages are by definition the riskier mortgages," Calhoun says. "The risk is particularly high right now when we are in a period of artificially low short-term interest rates because of the Federal Reserve's intervention. This seems to be a clear example of a time when you would want to require lenders to make sure that borrowers could afford the higher rates in the future."

Calhoun's warning notwithstanding, few lenders are approving nonqualified mortgages. Interest-only and payment-option ARMs disqualify home loans from meeting the qualified mortgage designation, too.

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