MONEY

The case for ARMs

Adjustable-rate mortgages have gotten a pretty bad rap since the housing market tanked a few years ago. After all, the over-availability of ARMs undeniably contributed to the housing bubble and following foreclosure wave. So readers of my recent piece in MONEY’s November issue, “Is it Time to Dump Your ARM?,” might have been surprised to see a recommendation that some homeowners refinancing out of one ARM should refinance into another one.

That’s because despite their flaws, hybrid ARMs, which start out with a fixed-rate period and then adjust on a recurring basis when that period is up, still represent a smart choice for educated borrowers who understand their risks. Yes, many borrowers got hoodwinked into ARMs that cost them their homes, but thousands of homeowners have also benefited from the savings provided by properly used ARMs. The mortgage gurus over at HSH Associates have written at length on this topic, in an interesting recent piece that argues that ARMs are “neither evil nor toxic.”

The ideal ARM borrower will have a fixed time horizon (no more than a year or so beyond the fixed-rate portion of their loan) and the wherewithal, both financially and emotionally, to absorb the higher payments that could come if the rate readjusts upward. And with rates near their nadir, it’s unlikely they’ll go much further down, especially when the economy starts to recover.

Still, with advertised rates for 5/1 jumbo ARMs at around 4.5%, you could save more than $450 a month on a $500,000 loan right now by refinancing into an ARM instead of a fixed-rate mortgage. Most 5/1 ARMs have a cap in the first adjustment year of 5 percentage points, meaning that in a worst-case scenario, your mortgage could jump to around 9.5%. That’s an ugly rate, but remember this is the worst possible case. And if you banked half the money you saved each month by choosing an ARM instead of a fixed-rate mortgage, you’d have enough funds to cover the added payments for almost a year until you moved or refinanced.

To be sure, ARMs aren’t the answer for all borrowers, and they’re certainly not the right product for borrowers who can’t afford a house without a low teaser rate. But neither should they be dismissed out of hand. For a primer on how ARMs work and the issues faced by borrowers, check out the Federal Reserve’s Consumer Handbook on Adjustable-Rate Mortgages.

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