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Time to Consider an Adjustable-Rate Mortgage?

Geoff Williams

Adjustable-rate mortgages are being welcomed into homes again.

Many homeowners shunned adjustable-rate mortgages, often called ARMs, during and after the recession, but according to an analysis from the trade publication Inside Mortgage Finance, the number of adjustable-rate mortgage originations shot up more than 40 percent from the first quarter of this year to the second, which was a major jump even accounting for seasonality.

If you're looking for a home, and you haven't been thinking about an ARM, you may wonder -- should the wisdom of the crowd be trusted? If you're looking for a new house, or if you're thinking of refinancing, might you want to get an adjustable-rate mortgage?

You might. You also might not. As usual, it depends on whom you talk to, and mostly, on your own financial situation and your own tolerance for risk. Let's walk through why ARMs became hated, why you may want to get one -- and why you may want to stay away.

[See: 10 Terms First-Time Homebuyers Must Know.]

Why some people hate them. ARMs start off with a fixed interest rate for a short period of time (often three years). Then the interest rate, just like its name suggests, adjusts. You may like how it changes (if the interest rate and monthly payment goes down), or you may not (if it goes up). During the last recession, ARM interest rates generally went up, and some of the ARMs were structured in devastating ways for the consumer (but in awesome ways for the banks).

For instance, some ARMs came with negative amortization, so you'd pay less than the minimum interest every month -- meaning the amount you owed on your mortgage increased rather than decreased.

ARMs are mostly better now, without those tricks, according to industry experts. Meanwhile, one trick that you should employ is a tip offered by the Consumer Financial Protection Bureau: Ask the lender to calculate the highest payment you may ever have to pay on any ARM loan that you're looking at. Lenders are required to give you that information on your Truth-in-Lending disclosure within three business days after applying for a loan. Then you'll know what the worst-case scenario with an ARM will be, and you can work from there.

Why you may want to get an ARM. If you want a low mortgage interest rate, this is the way to go. And to that, you might understandably ask, "Isn't that what everyone wants?"

Of course. But, as noted, ARMs can also go up, which is why not everyone gets one.

Still, this may be a good time to start reconsidering any dislike you have for ARMs. Fixed mortgage interest rates have been creeping up in recent weeks, and an expected interest rate hike from the Federal Reserve in December could have an effect, making future monthly payments higher.

David Doyle, consumer lending product and pricing executive at Bank of America, says that you're a good candidate for an ARM if these three situations apply to you.

-- You aren't going to live in the home for many years. He says if you know you will be relocating due to your career or because you'll be adding onto your family or downsizing (your kids are going to college), then you'd want to consider getting a hybrid ARM with terms of five, seven or 10 years. (That is, you start with a fixed interest rate for a period of five, seven or 10 years -- and then move to an adjustable rate.)

-- You know your income will go up. In other words, if you know you can cover the mortgage if your payment does go up and want to enjoy the lower interest rate in the meantime, you may want to consider an ARM. "You need to be ready for the adjustable rate feature -- and assume that your payment will adjust up," Doyle says.

-- If cash flow is a priority. If you struggle mightily with cash, then, obviously, maybe rethink buying a house. Doyle is talking about when your money supply is fine, but you have one big expense on the horizon. "For example," he says, "if a parent is putting a child through college, homeowners might want to evaluate the benefit of the lower initial monthly payment of an ARM. A lower mortgage payment may help them better manage their other monthly obligation."

[See: 9 Scary Things Consumers Do With Their Money.]

Why you may not want to get an ARM. For starters, it isn't as if fixed-rate mortgages are at an all-time high right now, points out Douglas Robinson, a spokesperson for the nonprofit NeighborWorks America, which supports community development and affordable housing in the U.S.

"Yes, it's not at its all-time low point, but fixed rates are very, very low," he says.

And what of the popular argument that a consumer takes an ARM, and if the rate increases later, he or she simply refinance?

The problem, Robinson asserts, is that it isn't always that simple.

"Many say, 'Well, when the rate goes up to a point above the prevailing fixed rate, I'll just refinance into a fixed rate,'" Robinson says. "But that's not easy to do if the homeowner's credit situation changed, or their income declined, or if the home value dropped. Yes, these are not the likeliest situations, but they do happen. Why take the risk for such a small difference in payment?"

[See: 8 Potential Headaches to Be Aware of Before Becoming a Homeowner.]

David Carey, vice president, residential lending manager at Tompkins Mahopac Bank in Mahopac, New York, has a similar concern. He isn't anti-ARM and says that some homeowners, particularly those who aren't going to live in the home for all that long, are "the perfect marriage of need and circumstance."

But he points out that "there is no way to predict where the interest rate will be when you're ready to refinance. So you may be faced with refinancing into a fixed rate higher than your current adjustable rate."

Which means, of course, that you'd stay with the adjustable rate, but it still might be much higher than you would like to be paying.

That is an unlikely scenario, though, Carey adds. "In most cases rates do not fluctuate wildly, even over a period of years," he says.

Still, it's something to think about. There is a risk to having an adjustable-rate mortgage. On the other hand, they aren't as risky as they used to be. These are mortgages that are a lot like greeting a stranger at your house. Just as the unknown guest on your doorstep could be a creep or a perfectly decent human being, you probably shouldn't immediately slam the door on an ARM -- and yet, you definitely don't want to usher it into your house without getting to know it first.



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