July 26, 2011 in Mortgages

Dear Dr. Don,
I would like to know the pros and cons regarding adjustable-rate mortgages. I was told they are locked in for five years. Is this correct?
— Bonnie Binding

Dear Bonnie,
An adjustable-rate mortgage, or ARM, can be structured in many different ways. The interest rate on an ARM is based on a pricing spread to an underlying interest rate. There can be an initial “teaser” rate, or a floor or minimum rate, a cap or maximum rate and limits on how much the interest rate can change on a reset date. The Bankrate feature on understanding adjustable-rate mortgages provides a nice primer on these issues.

An ARM that has its interest rate locked in for a multiyear period, such as a 5/1 ARM, is a hybrid mortgage product. The interest rate is fixed for five years and then resets every year, based on the parameters discussed. There are several different fixed-rate terms for a hybrid ARM, including 3/1, 5/1, 7/1 and 10/1. Bankrate reports the national average for a 5/1 ARM every Thursday in its Mortgage Analysis. You may also consider “interest-only” hybrid ARMs, where the borrower in the early years of the loan only pays the monthly interest expense on the loan amount.

ARMs typically have lower interest rates than fixed-rate mortgages because the lender is shifting the risk of higher interest rates over to the borrower. The interest rates on hybrid ARMs generally fall between the rates on fixed-rate mortgages and those on typical ARMs because the lender now faces the interest-rate risk for a set number of years.

Hybrid ARMs are best used when the homeowner is fairly certain he or she will no longer own the home by the end of the loan’s fixed-rate period. Try out Bankrate’s ARM or fixed-rate calculator to compare ARMs, hybrid ARMs and fixed-rate mortgages.

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