5-year ARM Loans More Attractive, but Still Risky

House on a PlateThe 5/1 ARM loan offers more potential savings today. The interest-rate spread between fixed and adjustable mortgages has widened over the last six months.

As a result, the 5-year ARM loan (recently considered the pariah of the mortgage industry) is making a comeback after a significant decline. But these loans still carry unique and significant risks, when compared to a traditional fixed-rate mortgage loan.

Let’s take a closer look at the pros and cons of 5-year ARM loans in 2011:

More Attractive Rates on 5-Year ARM Loans

The rate spread between the 5-year ARM loan and the 30-year fixed mortgage is wider today than it has been for some time. This makes the adjustable-rate mortgage more attractive to home buyers who want to minimize their monthly payments (at least for the first five years).

Here’s a comparison between today’s spread and what we saw four months ago, according to Freddie Mac’s weekly mortgage survey.

  • February 17, 2011: Average rate for a 30-year fixed mortgage was 5.00%. Average rate for a 5/1 ARM loan was 3.87%. The rate spread was 1.13%.
  • October 7, 2010: Average rate for a 30-year fixed mortgage was 4.27%. Average rate for a 5/1 ARM loan was 3.47%. The rate spread was 0.8%.

With the rate spreads we are seeing today, home buyers who choose the 5-year ARM over the 30-year fixed mortgage could lower their monthly payments by a couple hundred dollars or more. Even more significant, they could save thousands of dollars in interest costs over the first five years of the loan.

It’s what happens after the first five years that borrowers need to consider. The home buyer with the 30-year fixed mortgage loan will have the same interest rate and monthly payment after the five-year mark. The borrower with the 5-year ARM loan will see his interest rate and payments change, most likely by rising.

Buyer Beware: Adjustable Still Means Risky

In the long term, the 5/1 ARM loan carries more risk than a fixed-rate mortgage. This much is undeniable. So home buyers who are considering a 5-year adjustable mortgage should think about their long-term plans. There are basically two types of ARM loan borrowers.

  • Sell: The first group has a pretty good idea that they’ll only be in the home for a few years, perhaps in correlation with a temporary job transfer. They use the ARM loan to get a lower interest rate, thereby lowering their monthly payments as well. They know they’ll be selling the house and moving before the mortgage begins to adjust.
  • Refinance: The second group are the refinance gamblers. These are people who plan to stay in the home for many years, beyond the five-year period of fixed interest. Just like the first group, they use the 5-year ARM loan to reduce their interest rate and monthly payments. But instead of moving before the initial 5-year period expires, they plan to refinance into a fixed-rate mortgage.

Few people use the 5/1 ARM loan with the intention of hanging onto it for the roller coaster ride. Most borrowers fall into one of the two categories above. Note: These are not investors we’re talking about here, but rather home buyers who actually plan to live in the house.

There are risks associated with both of these scenarios. But the risks are higher with the second group. Here’s why. The chances that you can sell a house five years after buying it are better than the chances of refinancing the loan.

There are many more variables involved with the refi process. What if your credit score drops during the first five years? What if you lose equity due to home-price declines? What if you lose income due to job loss or a pay decrease? What if you can’t afford the closing costs on the new loan? All of these things can affect your ability to refinance the home.

But you can almost always sell your way out of an ARM loan, even in a buyer’s market.

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Bottom line: In both scenarios (sell or refinance), there’s a chance you will be stuck with your 5-year ARM loan through the first adjustment period. So have a plan for such scenarios.