The Smart Way to Use Adjustable-Rate Mortgages

The share of adjustable-rate mortgage applications for the month of December is nearing a low point the industry hasn't seen since 2001, but ARMs are unlikely to become a thing of the past, even though they can cause problems for homeowners who aren't financially disciplined.

ARMs are mortgages in which the interest rate can change, and payments are tied to an index such as the rate on U.S. Treasury bills. ARMs offer lower initial rates than fixed-rate mortgages to compensate the homebuyer for taking on the risk that rates could rise.

ARMs are down this week to a 9.8% share of total mortgage applications activity, from 10.4% the previous week. That's higher than in April 2001, the lowest point this decade, when it was a 7.4% share, but that low level didn't last long then -- by the same week of April 2002, ARMs had shot up to 16% of mortgage applications. The highest share of ARM applications this decade was 36.6% in March 2005, according to data from the Mortgage Bankers Association.

"Despite the plethora of news stories highlighting the horrific consequences of the subprime tsunami of 2007, homeowners still don't seem appropriately cautious about the use of ARMs. So ingrained is the notion that 'homeownership is the best investment you'll ever make' that consumers are likely to dive back in for more," says Manisha Thakor, co-author with Sharon Kedar of On My Own Two Feet: A Modern Girl's Guide to Personal Finance.

Poor housing affordability is still the primary reason homebuyers are looking toward ARMs, say some. The national median existing-home price for all housing types was $210,200 in November, down 3.3% from November 2006 when the median was $217,300, according to a Dec. 31 release from the National Association of Realtors.

"Even though national home prices have dropped a bit over the past year, homes still remain highly unaffordable in most markets," says Scott Anderson, a vice president and senior economist for Wells Fargo in Minneapolis.

With house prices still so high, the temptation to use an ARM that's affordable in the short term but could be beyond the buyer's means in the long term may be close to irresistible.

For example, if someone wants to buy a $200,000 house and the fixed-rate payment is $1,500 a month, but with an ARM it is $1,100, the applicant is going to qualify for a bigger or more desirable house with the ARM and its lower rate. The person is likely to buy a more expensive home at the lower rate, rather than sock away the $400 a month savings in an interest-bearing account. But if rates adjust upward on the ARM, they could go beyond the person's ability to pay, whereas with the fixed-rate mortgage the payments would stay the same.

"ARM's allow people to buy houses who shouldn't be buying houses. The majority of Americans are not disciplined enough to save money [to be able to] afford to pay their mortgage when the rate increases," says Jason R. Hanson, author of the book How to Build a Real Estate Empire.

"When reckoning day comes," he says, "they will be reminded they bought too much house. [But] people want immediate gratification, therefore people will continue to get ARMs and not worry about the consequences down the line."