Contrarian mortgage advice: Maybe an ARM is a good idea

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As mortgage rates plunged last year, adjustable-rate mortgages, or ARMs, all but vanished. For homeowners flocking to fixed-rate loans, the rationale is obvious: Why flirt with interest rate risk when you can get a super-low fixed rate for the life of the loan?

With rates expected to rise in the coming months, ARMs are likely to remain a second choice for borrowers. But one lender argues that ARMs aren’t as scary as they seem.

In fact, adjustable-rate loans can be a money-saver for some borrowers, says Jerry Anderson, vice president of residential lending at Alliant Credit Union in Chicago. He says ARMs can make sense for borrowers who expect to move in five to seven years.

“If you can save half a percent on your interest rate versus a 30-year fixed, that’s a great savings,” Anderson says.

How ARMs work

To decide if an ARM makes sense, you first need to understand the rules. Most ARMs come with fixed rates for the first five, seven or 10 years of the loan, and after that the mortgage rate can rise or fall depending on prevailing interest rates.

The amortization schedule is the same for an ARM as for a 30-year fixed-rate mortgage. ARMs generally carry lower interest rates than fixed-rate mortgages, although that rule of thumb didn’t hold true during the depths of the coronavirus pandemic.

After the fixed-rate period of the ARM ends, the rate then will move to reflect market rates. ARMs long tracked the London Interbank Offer Rate, but ARM rates now are based on a metric known as the Secured Overnight Finance Rate.

After the ARM’s fixed-rate period ends, the rate can typically adjust every six months, moving up no more than 1 percentage point at a time, Anderson says.

Why an ARM could make sense

While rates for 30-year mortgages remain historically low, ARM rates are even lower. Alliant Credit Union’s rate on a seven-year ARM is 2.375 percent, compared with 3 percent for a 30-year fixed-rate loan.

Anderson offers this scenario: Say you borrow $300,000. With the 30-year loan at 3 percent, your monthly payment would be $1,265. But with a seven-year ARM at 2.375 percent, your payment would fall to $1,166.

That’s a savings of $99 a month, or $8,316 over the seven years that the rate is fixed. And if you held onto the loan even after seven years and rates had risen, the first rate adjustment of 1 percentage point wouldn’t break your budget — the monthly payment would go up to $1,326 a month.

So, Anderson says, if you expect to move within five to seven years and sell the house, an ARM makes sense.

Why not to take an ARM

Of course, there is risk with an ARM. Greg McBride, Bankrate’s chief financial analyst, cautions against taking an adjustable-rate loan at the moment.

“There are times when that is savvy advice,” he says. “I’m just not sure now is one of those times.”

Why not? Many lenders aren’t offering especially attractive deals on ARMs. The average rate on a five-year ARM as of last week was 3.04 percent, compared with 3.21 percent for a 30-year fixed-rate loan, according to Bankrate’s national survey of lenders. This week, however, the gap widened — the five-year ARM plunged to 2.9 percent, compared to 3.2 percent for the 30-year fixed.

“When that is particularly advantageous is when there is a measurable difference between the rate on a hybrid ARM and what you can get on a 30-year fixed,” McBride says. “That difference is much more scant today, so why take the risk?”

While some lenders, such as Alliant Credit Union, offer more enticing deals, Anderson offers his own caveat: If you plan to stay in the house for a decade or longer, don’t bother with an ARM.

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