To reduce risk, first shop around, educate yourself about loan products and know your time horizon. — Getty Images
En español | Deciding on a home mortgage can be tricky business for older borrowers — especially if they're trying to choose between a conventional 30- or 15-year fixed-rate mortgage and an adjustable-rate loan (ARM).
ARMs offer the potential for big savings — a temptation to many homeowners in or near retirement and who want to lower household fixed costs. So should you take an ARM the next time you buy a home, downsize (or trade up) to a new place, or think about refinancing?
"With an ARM, you might free up many hundreds of dollars per month," says Keith Gumbinger, vice president at HSH.com, a mortgage information website. "That money could be put into your 401(k) or even stuffed back into your house, letting you lower your mortgage balance and build equity." (Disclosure: I've written freelance articles for HSH in the past.)
"But the problem with ARMs," says Gumbinger, a veteran mortgage pro with more than 30 years in the industry, "is that they're not without risk."
Guy Cecala, CEO of Inside Mortgage Finance, also acknowledges the risks inherent in ARMs. But he thinks they're currently a very good idea, given expectations for interest rates.
"Right now, nobody expects rates to decline," says Cecala. "We feel there's only one direction rates can go right now, and that's up. So if borrowers are looking for sub-4 percent rates, the new reality is that there are a lot of ARM products that look really attractive."
Here are four tips that can help you determine whether an ARM is right for you.
1. Know your alternatives
With most ARMs, the interest rate and monthly payment change at specific intervals: usually every month, quarter, year, three years or five years. The period between rate changes is called the adjustment period. So a loan with an adjustment period of one year is known as a one-year ARM, and its interest rate and payment can change once every year.
A loan with a three-year adjustment period is a three-year ARM. But there are also so-called hybrid ARMs such as 5/1 ARMs and 7/1 ARMs, which are increasingly popular. These loans are a hybrid between mortgages with a fixed-rate term and those with an adjustable-rate period. With a hybrid ARM, the interest rate is fixed for the first few years, and after that, the loan adjusts annually until it's paid off.
A few lenders, such as Pentagon Federal Credit Union, offer 5/5 and 15/15 ARMs. With a 5/5 loan or a 15/15 loan, the ARM sets at an initial rate and then resets again and stays at that level for a fixed period. For example, a 5-5 ARM might have a 3.5 percent introductory rate for five years. When the loan resets five years later, it maintains the new, adjusted rate for another five years, repeating the cycle every five years.
"If rates are lower or about the same, great," Gumbinger says. "But if rates are much higher and your loan adjusted, now you're stuck with it for five more years. So it's a double-edged sword."
From his perspective, Cecala thinks PenFed's 5-5 ARM "could be the best of both worlds" for borrowers with a five- to 10-year horizon. That's because the loan starts out at an ultra-low 3 percent rate (as of late May) and has a 2 percent cap on the first adjustment. "That starting rate saves you a lot of money for the first five years," Cecala says. And with a maximum rate of 5 percent for the following five years, "that's nearly comparable to today's fixed-rate mortgages," he says.
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