Pros and cons of adjustable-rate mortgages

Dear Dr. Don,
On the so-called ARM loans like a 5/1 ARM, what is this intended for? Does it favor the lender or the client? Can we refinance a 5/1 at the end of the first three years?
-- Robert Redux

Dear Robert,
A 5/1 ARM is a hybrid mortgage. A typical adjustable-rate mortgage resets annually. A 5/1 ARM has a fixed interest rate for the first five years before it adjusts to a new rate based on the short-term interest rate it is priced on and the pricing spread.

Lenders like adjustable-rate mortgages because they shift interest rate risk to the borrower. The hybrid ARM allows the borrower to get a lower interest rate than a 15-year or 30-year fixed-rate mortgage because the borrower accepts the interest rate risk after the initial fixed-rate period.

Hybrid ARMS are available as 3/1, 5/1, 7/1 and sometimes even as 10/1 structures. They can benefit the borrower if the borrower doesn't expect to be in the home much longer than the fixed-rate period. So the lender and the borrower can get to win-win by setting an initial fixed-rate period that suits the borrower..

Your ability to refinance a 5/1 ARM depends on where interest rates are at that point in time and the cost of refinancing, including whether there's a prepayment penalty. It would be pretty unusual for a prepayment penalty to go out past three years, but the loan agreement would spell that out upfront.

In general, you shouldn't go into a 5/1 ARM with the idea that you'll be able to refinance at a lower rate down the line. We're at the end of a period of Fed easing, and the Federal Reserve has already started a cycle of tightening, which means rates are going up. What its mindset will be three to five years from now nobody knows, but counting on refinancing to be advantageous during the fixed period of a 5/1 hybrid ARM doesn't make sense. Bankrate's Mortgage Adviser can help you decide which mortgage structure best meets your needs.