Mortgage 101: Is an ARM Right for You?

Borrowers have forsaken adjustable-rate mortgages. In its latest survey, the Mortgage Bankers Association said ARMs accounted for just 2.3% of loan applications for the week ending May 8, down from more than 30% in the middle of the decade.

Is the ARM really such a bad choice?

For most people, it probably is. But ARMs may be suitable for a handful of borrowers who shop carefully, don't expect to keep their loans for long or are willing to take on substantial risk to bet that interest rates will stay low.

Most borrowers are better off with fixed-rate mortgages, which are terrific bargains these days. The 30-year fixed loan averages about 5%, and the 15-year variety just 4.8%, according to the BankingMyWay.com survey.

Meanwhile, one-year ARMs start at about 5%. Generally, an ARM should start about 2 percentage points lower than a fixed loan to be attractive, and even then it may not be.

The one-year ARM charges the advertised rate for 12 months, then adjusts up or down by adding a given number of percentage points, or "margin," to the rate on an underlying index. So long as the index stays low, your rate will stay low. Many ARMs cap rate changes at 2 percentage points a year and 6 points over the life of the loan.

Three-year, five-year and seven-year ARMs keep the initial rate for the stated period, then reset the rate every 12 months. Bank of America (BAC Quote) has an ARM that charges just 3.875% for the first five years, while Wells Fargo (WFC Quote) has a similar loan charging 3.75%.