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adjustable_rate_loan_concept(MCT)—The Mortgage Bankers Association reports that only about 1 of every 10 home mortgages being written today carries an adjustable interest rate. A combination of negative press on adjustable-rate mortgages and a widespread belief that interest rates are bound to start rising in the near future has induced extreme caution among borrowers—as if the only proper response to risk is its complete avoidance.

But risks are worth taking when the benefits are large and the downside is known and manageable. This is the case for hybrid ARMs that have a fixed-rate period of some years at the beginning, before annual rate adjustments kick in. My impression is that too many borrowers are taking fixed-rate mortgages as the easier path without considering whether an ARM might serve them better. The purpose of this column is to describe the factors that prospective borrowers ought to consider before making a decision on whether they want an FRM or an ARM.

On June 9, well-qualified borrowers using my website were offered the following choices: a 30-year fixed-rate mortgage at 4 percent, a 10/1 ARM at 3.5 percent, a 7/1 ARM at 3 percent, and a 5/1 ARM at 2.625 percent. (Fees and charges were about the same for all four choices, and all have terms of 30 years). The initial payments on these loans are calculated using these rates. On a $300,000 loan, for example, the initial payments, in the same order starting with the FRM, were $1,432, $1,347, $1,265, and $1,205. The rate and payment on the FRM are fixed but on the ARMs they can change.

The initial rate and payment on a 10/1 ARM holds for 10 years. At the end of the 10-year period, and then every year thereafter, the rate is adjusted to equal the value of the rate index at that time plus a margin of 2.75 percent. The index right now is 0.1 percent, which contributes to the view that rate increases are inevitable.

At each rate adjustment, the payment is recalculated at the new rate over the period remaining. No rate change can exceed 2 percent, however, and the maximum rate cannot be more than 6 percent above the initial rate. The 7/1 and 5/1 ARMs are exactly the same, except that the first rate and payment adjustments occur after 7 years and 5 years, respectively.

If borrowers knew with certainty how long they would have their mortgage, their decision process would be relatively simple. If their expected mortgage life was less than 5 years, they would take the 5/1 ARM which has the lowest rate, and they would be out of it before the first rate adjustment. As their time horizon lengthens, at some point they would shift to the 7/1, then to the 10/1, and finally to the fixed-rate.

While very few borrowers know with any degree of certainty how long they will have their mortgages, most can hazard an informed guess. This guess should be an important part of their mortgage selection process.

The purpose of taking an ARM rather than an FRM is to reduce costs, but there is the risk that if interest rates rise and the borrower keeps the ARM too long, its cost will be higher than that of the FRM. But how long is too long?

To answer that question, I calculated total mortgage costs year by year for the FRM and for the three ARMs noted above. For the ARMs I did it on the assumption that interest rates increased by the largest amount permitted by the loan contract — a worst case. This allowed me to answer this question: If ARM interest rates increase as much as possible, how long must the borrower have the mortgage before the lower cost of the ARM than the FRM becomes a higher cost?

As an illustration, if the borrower takes the 5/1 ARM and doesn’t pay it off until Year 6, he or she still comes out way ahead. The total cost of the ARM would actually be lower until Year 9. On a 7/1 ARM, the borrower benefits if he or she is out of the mortgage before Year 11, and on a 10/1 ARM before year 13. I calculated these numbers using calculator 9ai on my site.

An important factor in the mortgage-type decision is the borrower’s capacity to meet the larger payment resulting from an ARM rate increase. Because ARM rates are capped, it is possible to calculate the highest possible payment that would result from a worst-case interest rate scenario. For example, if the interest rate on the 5/1 ARM rose from 2.625 percent to 8.625 percent, which is the largest increase the contract allows, the payment on a $300,000 loan would rise from $1,205 initially to $2,124 in month 85. The largest payments on 7/1 and 10/1 ARMs would be $2,132 reached in month 109, and $2,131 in month 145. Readers can find these numbers for their own mortgage on my website as Step 2 on the “Find Your Mortgage” page.

The 30-year FRM is a great instrument for borrowers who expect to retire in their current home, or who cannot anticipate that they will have the capacity to make higher mortgage payments in the future. Others ought to consider taking an ARM. Yes, interest rates are bound to go up, but rates were bound to go up four years ago, and here we are.

Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania.

©2014 Jack Guttentag
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