Risks, rewards of adjustable-rate mortgages

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Even with mortgage rates near historic lows, not everyone gets a 30-year fixed-rate loan. Some homeowners choose adjustable-rate mortgages, or ARMs.

ARMs have a mix of rewards and risks.

Among the rewards: Borrowers choose ARMs because of the lower interest rates and lower initial monthly payments, says Gilles Gade, CEO of Cross River Bank in Teaneck, N.J. In recent months, rates on 5/1 ARMs have been about 1 percentage point lower than on 30-year fixed-rate loans, which can mean a significant savings in the first few years of the loan, he says.

“Homeowners pay less for their mortgage and at the same time fulfill the dream of owning a new house,” he says.

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Chief among the risks: Interest rates can go up. If interest rates rise, mortgage payments would rise. “The No. 1 risk is interest rate risk, where the interest rate can go up over time,” says Gibran Nicholas, CEO of CMPS Institute, a national organization that certifies mortgage brokers and bankers in Ann Arbor, Mich.

With rates near historic lows in mid-2012, they are likely to be higher when ARMs reset, he says. If you’re considering financing with an ARM, make sure the mortgage suits your situation and that you understand the rewards and risks.

Short-term financing

Homeowners who know they will move in a few years — perhaps within five or 10 –should consider ARMs, Nicholas says.

“If you have a 5/1 ARM or 7/1 ARM and you plan to be out of the house before the five or seven years is up, then it could make sense to get the loan and the lower payments,” Nicholas says. However, buyers should prepare to stay in their home longer than their original plans, in case circumstances change, he adds.

If you hope to move within three or four years, consider borrowing with a 5/1 ARM, which resets in five years, instead of a 3/1 ARM, which has a shorter fixed-rate period, Nicholas says. “Give yourself a little bit of time in case the market doesn’t cooperate when you’re ready to sell your home,” he says.

Expecting a promotion

ARMs could also be a solution for borrowers who need a lower payment today but expect a big pay raise within a few years, says Bill Hammer, a Certified Financial Planner in Melville, N.Y. “If you think your earnings will increase dramatically in the next three or four years but you need the extra cash flow for expenses right now, I think an ARM tends to be a nice solution.”

But if the bump in pay doesn’t materialize, the borrower could be stuck with hard-to-afford mortgage payments after the rate resets, he says.

Jumbo mortgage borrowers

Homeowners who need to borrow large amounts of money may have to take out jumbo loans — mortgages that are too big to conform to Fannie Mae and Freddie Mac guidelines. In much of the country, a jumbo loan is a mortgage of more than $417,000; that amount is higher in high-cost housing markets, topping out at $729,750.

Jumbo mortgages have higher rates, so borrowers may consider ARMs as an alternative, Nicholas says. “They can allow you to get a lower rate than with a fixed, nonconforming mortgage,” he says. The risk, again, is that rates could be higher when the loan resets, Nicholas says.

However, if the homeowner saves enough money while building equity, it might be possible to do a “cash-in refi” in the future. With a cash-in refi, the homeowner partially pays down the mortgage — enough so that the remaining balance can be refinanced with a conforming loan. It’s a neat balance between rewards and risks.