Despite Rate Drop, ARMs Still Risky

Interest rates on adjustable-rate mortgages (ARMs) have declined over the past few weeks, just as rates on fixed-rate mortgages (FRMs) have trended upwards. But despite this shift, you still might want to think twice before applying for an ARM.

In mid-January, interest rates on five-year ARMs averaged 0.8 percentage points higher than the rates offered on 30-year FRMs, according to BankingMyWay.com's Rate Index. But since then, the gap has all but disappeared. Interest rates on five-year ARMs have dropped to 5.38% while rates on 30-year FRMs have risen to 5.36% -- a difference of just 0.02 percentage points.

The drop in the average rate on ARMs has caused a stir in activity among such mortgages, but homebuyers remain wary -- ARMs still account for only 2.3% of total mortgage applications, according to the Mortgage Bankers Association. The reluctance to embrace ARMs is well-founded: despite currently low interest rates, there are still significant long-term risks to applying for an ARM.

On a $200,000 mortgage, a five-year ARM with an initial rate of 5.38% might cost you $85,000 more in interest over the life of the loan as compared to a 30-year FRM at 5.36%. And that's provided your rate only adjusts upwards a maximum of 0.25% each year after the first five years of the initial rate.

If rates rise faster than that -- and some analysts predict that double-digit interest rates could go hand-in-hand with a recovering economy -- the extra cost of that ARM could easily reach $150,000 or more in added interest charges. To see for yourself, check out BankingMyWay.com's ARM vs. Fixed mortgage calculator.