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As rates rise, so does the popularity of ARMs

When mortgage rates are rising, it seems counterintuitive to take out an adjustable-rate mortgage. But that's exactly what almost one-third of borrowers are doing.

Adjustable-rate mortgages, or ARMs, made up 32.7 percent of loan applications last week, according to the Mortgage Bankers Association. That was an increase over the previous week. Borrowers are flocking to ARMs even as the entire mortgage industry believes that rates will rise this year and next. The rates on today's ARMs probably will go up when the adjustment period rolls around.

Why, if rates are likely to rise, would anyone want to get an ARM? There are reasons, some of them good. The key is that ARMs have lower rates than fixed-rate mortgages. On a one-year ARM based on the constant maturity Treasury, the rate typically is at least two percentage points lower than the rate on a 30-year fixed. Rates are almost as good on hybrid ARMs, which sport initial rates that last three to 10 years, then adjust annually after that.

For example, a 5/1 hybrid ARM starts out with a rate that stays the same for five years, then adjusts every year thereafter. Rates on these loans generally run between 1 and 1.5 percentage points lower than rates on 30-year fixed mortgages.


These hybrid ARMs have become popular in the last few years as homeowners have learned to match their loan to the length of time they think they'll own their homes.

Key: How long will you stay?
"When I consult someone, I frequently ask them how long do they plan on staying in the home," says Bob Moulton, president of Americana Mortgage Group in New York. They always say they don't know, and Moulton presses further. How long did they live in their previous home? How long did they live in the house before that? Do they plan to have children? Will any children move out within a few years? Is there a possibility of a job transfer or a big pay raise in the next few years?

More often than not, Moulton's clients conclude that they won't stay in the house for the life of a 30-year, fixed-rate mortgage. A typical homeowning family stays in the house seven or eight years before moving on. So a typical family, in the opinion of Moulton and many other mortgage lenders, should get a hybrid ARM.

Homeowners with adjustable-rate mortgages often refinance right back into ARMs, forgoing the opportunity to grab near-record low rates for fixed-rate loans. Moulton says a client of his got a 5/1 ARM in February 2003 because she intended to sell the house within five years. She called Moulton a few weeks ago to say that her plans had changed, and that she wanted to keep the house a year or two longer than she originally intended. "So I refinanced her into a seven-year ARM vs. the four years she had left on her five-year ARM," he says.

Think rates, not just payment
Many borrowers focus on the lower monthly payment at the beginning of an ARM's term and don't worry too much about what will happen if rates rise sharply in the future.

"Generally speaking, in a rising rate environment you're going to have more people refinancing into an ARM," says Garrett Brief, vice president for product development for mortgage lender IndyMac Bank. "If they're looking to get cash out of their property and they still want to avail themselves of a low rate, the product that will allow them to do that is an ARM."

That might sound backward to people who think of themselves as cautious with their money. If you get a fixed-rate mortgage while rates are low and rising, you're locking in a low rate for the life of the loan, whereas someone who gets an ARM risks rising rates and bigger payments in the future. But there's another way to think about it. Call it the Bird in the Hand theory: Get an ARM and save money now when the savings are a sure thing.

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The rock-bottom savings come with interest-only ARMs, in which the borrower pays only the interest and not principal. Interest-only ARMs are "a great idea for someone starting out," says Gary McCann, executive vice president for Astoria Federal Savings. "Hopefully, at one point in time, their income goes up and they can start paying toward principal."

But they're not such a good idea for people who lack the self-discipline or the income to make payments toward principal.

Most borrowers who get hybrid ARMs, whether or not they're interest-only, plan to either move out of the house or refinance before the fixed-rate period expires. But if they keep the loan until the rate adjusts, they get one to four months' notice of what their new interest rate and payment will be.

-- Posted: April 29, 2004
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See Also
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