Hybrid adjustable mortgages offer advantages

The percentage of mortgage borrowers opting for adjustable rate mortgages (ARMs) has been on the rise as mortgage rates have been on the rise. At first glance, one might shudder at such news, thinking that borrowers are venturing into risky territory and forsaking the peace of mind that comes with a fixed-rate mortgage when rates are still at historically attractive levels.

There is no doubt that some borrowers do indeed fall into this camp. However, the recent rise in the popularity of ARMs is not in itself alarming. In fact, more borrowers should look to certain ARMs regardless of the interest rate landscape. Who does this describe? Anyone buying a starter home, borrowers subject to job transfers or future promotions, or anyone with the likelihood of a growing family that requires a larger home in the future. With homeowners frequently moving within seven to 10 years, many borrowers are better suited for a hybrid ARM than a traditional fixed rate mortgage.

The ideal mortgage for such borrowers is one that has a fixed rate for an initial period of years that coincides with the borrower's intended time horizon in the home. Only then does the rate become adjustable. What results is a mortgage that has a fixed rate for the time the homeowner expects to occupy the home, with any rate adjustments not due until after the homeowner intends to move on. The clincher is that the initial fixed rate is lower than what is found on a traditional 30-year fixed rate mortgage.

What does the higher interest rate on a 30-year fixed rate mortgage guarantee to a borrower that might otherwise benefit from a mortgage such as a 7/1 or 10/1 ARM? The 30-year fixed offers an assurance of a fixed rate eight years or 11 years down the road should the intended timetable not pan out. While this may bring along some peace of mind, particularly when the fixed rate being locked in now is at one of the lowest points in generations, the borrower must assess the odds of actually living in the home beyond the initial fixed period.

Look at the cost, in the form of extra mortgage payments, doled out for an option that may never be exercised. Consider a 30-year fixed rate mortgage at 6.5 percent vs. a 7/1 ARM at 6 percent. (See table below.)

Over the first seven years, the ARM saves $4,500 in total payments and still builds nearly $1,300 in additional equity. Given those savings, many homeowners in such a situation are better served taking a mortgage suited to the likelihood that they will sell the home at some point in the next seven years, and not a loan that accommodates the much smaller chance that they will not.

OK, so what if the horizon doesn't pan out and now the borrower faces annual rate adjustments in a potentially hostile interest rate environment? Don't forget the savings tallied in the first seven years. If the homeowner now plans on living in the home indefinitely, he or she can use some of those savings to refinance into a fixed rate loan. For a shorter horizon that is now more clearly defined than when the home was initially purchased, the borrower can refinance into another ARM suited to that horizon, or just stomach the rate increases in the meantime. Living with the annual rate adjustment can mean a significant jump in monthly payments. However, even if the rate jumped from 6 percent to 11 percent at the first adjustment, it would take an entire year of the higher payments to erase the savings accumulated in the first seven years.

For borrowers with a good chance of moving within the next 10 years, a hybrid ARM is an appropriate loan choice. The savings accumulated relative to a fixed rate mortgage give the borrower some breathing room in the event circumstances change. But even if some of the initial savings are later devoured, many borrowers will be better off having gone with the ARM than not.