Is an Adjustable-Rate Loan Too Good to Pass Up?

By Carla Fried

If you're contemplating buying a home, or refinancing, mortgage rates are certainly working in your favor. Cheap doesn't seem sufficient to describe today's 4.6 rate on a 30-year fixed rate loan. At the risk of showing my age, I remember when the 30-year fixed was above 10 percent. (1990, okay?) And just 10 years ago we were staring at 7 percent and thought that was a pretty good deal as well. So 4.6 percent is ridiculously low.

But it's not as low as you can go. Adjustable rate mortgages are of course, even less expensive. A 5/1 ARM in which the interest rate stays put for five years before it can be adjusted has an initial interest rate of 3.2 percent. Factor in the value of your mortgage interest deduction and your effective rate could be close to 2 percent. That's hard to pass up, and over the past year, ARMS have become more popular.

But all the same, if I were in the market right now I would not flinch for a second and stick with the 30-year mortgage. For a couple of reasons:

• I’m picky about where I want to take on risk. We can all do the math on the savings that come with opting for the 5/1 ARM over the 30-year, but with that lower rate I'd have to take on the risk of what happens after five years. Most ARMS can adjust up to 2 percentage points a year, with a maximum increase of 6 percentage points. So worst case scenario is that if the general trend of interest rates heads up over time, I could be stuck with a 9 percent interest rate. I have to take risk in my 401(k) to have a chance at inflation-beating gains that stocks deliver. I don't care to take risk in my home as well.

• I am not big on assumptions. Ok, so it's absolutely true that I could refinance out of my ARM if in fact year five rolls around and interest rates are indeed higher. But that depends on a few faulty assumptions. If ARM rates are higher, fixed rates will be higher too. Just saying. And if we've learned one thing as the real estate bubble has deflated, is that it's not exactly a given that you will be able to refinance. Maybe you won’t have built up enough equity. Maybe lending standards will have gotten tougher (scary thought, eh, given where they are today) or maybe your financial situation has changed-new job, layoff, moving to part time-so you might not qualify based on your current earnings. Just because you want to refinance doesn’t mean you can assume you will be able to refinance.

• I have no intention to move within 5-7 years. A 5/1 ARM begins to make a little more sense if you are sure you will move before the ARM hits its first potential adjustment. I'm hoping to stay put for a while, so count me out. And if you're going to move in a few years, I wonder if you should be buying in the first place. After paying the agent's fee and accounting for other moving costs you can easily be looking at forking over 8 percent to 10 percent of the sale price. Are you sure you're going to get at least that much appreciation during the time you own, to offset those costs? The worst of the price declines is over, but we could still be in a for a few years of stagnated prices as some areas have a big backlog of foreclosed and distressed homes to sell. Banking on 10 percent appreciation might be pushing it a bit.

• We're at a pivot point in the interest rate cycle. We don’t know when interest rates will start to rise; but we do know they are at historical lows. Long-term the trend is for interest rates to rise. If you're in an ARM that spells higher payments down the road. Me, I'm just fine settling for a slightly higher fixed rate loan that will never move a penny on me. Sure, 3.2 percent is great. But so too is a 4.6 percent rate that I don't have to worry about.