Adjustable-rate mortgage can work out well, but it has risks

USA Today

Years from now, homeowners will remember the summer of 2003 as the golden age for home mortgages. The average rate for a 30-year fixed loan plummeted to 5.2%. Home sales surged, and mortgage lenders had to hire bouncers to handle the lines outside their doors.

Unfortunately, the good times didn't last. Fixed-rate mortgages have been creeping higher for months. Last week, the average rate for a 30-year mortgage was 6.3%, according to mortgage investor Freddie Mac.

The rate increase prompted many home buyers to seek refuge in adjustable-rate mortgages. But now, that golden age also appears to be ending, and borrowers need to re-evaluate whether the rewards of an ARM outweigh the risks.

The average rate for a one-year adjustable-rate mortgage jumped to 4.14% last week, up from 3.98% a week earlier, according to Freddie Mac. Five weeks ago, the average rate for a one-year ARM was 3.76%.

Adjustable-mortgage rates are sensitive to short-term interest rates, says Keith Gumbinger, vice president of HSH Associates, a mortgage consulting firm. The Federal Reserve Board is expected to raise short-term interest rates at the end of this month in an effort to keep inflation under control. Some economists believe the Fed will raise rates several times this year, putting more pressure on adjustable rates.

Fixed-rate mortgages, meanwhile, are more affected by long-term interest rates and inflation expectations. A Fed rate increase already has been factored into long-term rates, so fixed-rate mortgages aren't expected to rise as quickly in the next few weeks as adjustable loans.

As a result, the difference between fixed and adjustable rates — known as the spread — likely will narrow in the weeks ahead, reducing the initial savings from an ARM.

Right now, the savings are still significant.

On a $200,000 mortgage, for example, a 30-year loan would cost you $1,238 a month, vs. an initial $971 for a one-year ARM.

But if ARM rates continue to climb more quickly than fixed rates, borrowers will need to decide whether the initial savings from an ARM justify giving up the security of a 30-year fixed rate, Gumbinger says.

Reviewing your options

ARMs still make a lot of sense for people who don't expect to be in their homes for very long. Even if you're not a big risk-taker, you may find one that fits your needs.

Many lenders offer hybrid ARMs, which offer a low initial rate for a specific period, then adjust annually to reflect market conditions.

"So many consumers are moving every four to seven years that perhaps an ARM isn't as risky as one might think," says Dave Herpers, director of consumer affairs at Amerisave Mortgage, an online mortgage provider.

Merrill Lynch recently introduced a product that combines features of adjustable- and fixed-rate mortgages. The interest rate adjusts every six months based on the six-month London Interbank Offered Rate index.

The loan increases, or decreases, only half as much as a traditional ARM, says Larry Washington, chief executive of Merrill Lynch Credit.

"We know the predictions are that interest rates are going to rise," he says. "This loan allows you to fix half of your payment and only let the other half of it adjust."

The blended rate is available for three, five or seven years. After that, the mortgage will adjust semiannually based on the LIBOR, plus a margin of 2%.

It's no surprise that lenders are coming up with new kinds of ARMs. Adjustable-rate mortgages accounted for nearly 35% of all new mortgage applications during the first week of June, according to the Mortgage Bankers Association. A year ago, they accounted for only 14% of all mortgages.

Demand for ARMs usually goes up when rates on long-term mortgages increase. But with housing prices still high in some parts of the country, the popularity of ARMs has raised concerns that some home buyers are using them to buy homes they couldn't otherwise afford.

When deciding between an ARM and a fixed-rate mortgage, spend some time contemplating worst-case scenarios. Make sure you have the financial wherewithal to cover an increase in your monthly payments if interest rates are higher when your rate adjusts.

If you can't handle the uncertainty, or if you think you'll stay in your home for a long time, you may be better off with a fixed-rate mortgage.

Fixed rates are still low by historical standards. In March 1987, for example, the average rate on a fixed-rate mortgage hit 9.09%, according to HSH Associates. By that measure, we're still in a golden age.

Sandra Block covers personal finance for USA TODAY. Her Your Money column appears Tuesdays. Click here for an index of Your Money columns. E-mail her at:

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