Don't be deceived by low ARM rates
By Greg McBride • Bankrate.com

Adjustable mortgage rates have consistently dropped through much of the year, unlike the alternating up and down movements of fixed-rate mortgages. The last time adjustable mortgage rates were appreciably lower than the current level was 1993-1994.

But do not be deceived by these low rates. Fixed-rate mortgages are not far removed from the record lows established in November, and remain well below the 7 percent mark. In such a low rate environment, especially an environment that has prevailed for nearly 18 months, adjustable-rate mortgages are not a mass appeal product.

Adjustable-rate mortgages, or ARMs, are a niche product that appeal to consumers in certain situations. When rates are high, this net is cast a little wider and encompasses a broader group. But with fixed rates so low, what situations would warrant passing up an ultra-low fixed rate for the even-lower, yet uncertain, adjustable rate?

Perhaps the most prevalent are borrowers moving into starter homes they plan to occupy for only a few years before upgrading. Such borrowers can obtain hybrid ARMs, which are fixed for an initial period of years before becoming adjustable. Examples include a 3/1, 5/1, 7/1 or 10/1 ARM. The shorter the initial period, the lower the initial rate.

The details are crucial. The initial fixed period must exceed the borrower's intended time horizon in the home. If so, the loan essentially functions as a fixed-rate loan, at a rate lower than traditional fixed rate loans, during the time the borrower occupies the home. If this initial period expires before the borrower has moved on, the rate becomes adjustable. However, it still may take a couple years before the benefit of the initial lower rate is offset.

A similar circumstance is a borrower who is subject to frequent job transfers, but who wants to build equity rather than just rent. The aforementioned hybrid ARMs make a fine option in this case as well.

People who can reasonably expect substantial pay increases in coming years also may be comfortable taking an ARM initially, just to get into a home they otherwise could not afford on a fixed-rate loan. The idea is that future income will rise faster than either the adjustable rate or the cost of refinancing into a fixed rate loan. Of course, defining oneself as one who can reasonably expect a sharp increase in income is highly subjective. Needless to say, this doesn't refer to the lottery hopefuls, but rather young professionals in high-paying fields, such as doctors with growing practices or lawyers with good prospects of making partner at their firms.

Some borrowers opt for interest-only mortgages to maximize their tax deduction while minimizing their debt service. The pitfalls here are that the borrower builds no equity other than what is attributable to property appreciation; rates are often adjustable either during or after the interest-only term; and balloon payments are often needed.

If looking to avoid the balloon payment, borrowers are forced to refinance before the interest-only period expires. This can put them in an amortizing mortgage with terms less favorable than what would have originally been found when the home was initially purchased.

Further, not building any equity by chipping away at the loan principal can be a dangerous proposition in lieu of a significant down payment and if property values nosedive. Such a scenario could leave a borrower owing more than the home is worth, even after several years of making monthly payments.

Fixed mortgage rates will inevitably begin to climb. When they do, lenders will begin placing greater emphasis on adjustable-rate mortgages. But fixed mortgage rates have a long way to rise before borrowers should begin looking at other loan options.

At this stage, if a borrower doesn't fall into one of these niches, and still can't afford the monthly payment on a fixed rate loan, they're looking at the wrong house, not the wrong loan.

Greg McBride is a financial analyst for Bankrate.com.

For advice regarding your specific situation, please e-mail one of Bankrate.com's Q&A experts or visit the Advice channel on Bankrate.com.

-- Posted: May 31, 2002