This Day On The Street
Continue to site
This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here

Cautious Home Buyers, It's Time for a Farewell to ARMs

NEW YORK ( TheStreet) -- For several years we've suggested that borrowers with a stomach for risk take a look at the five-year adjustable-rate mortgage, which could be considerably cheaper than the standard 30-year fixed-rate loan that dominates the market.

But not anymore. Rising interest rates and a projected slowdown in home-price appreciation make the five-year and other ARMs too risky. For most borrowers, this is a time to lock in a long-term fixed rate -- and to congratulate themselves if rates rise down the road.

ARMs charge the advertised rate for the initial period of one to seven years, then adjust the rate every 12 months to rise or fall with market conditions. The initial rate is often substantially lower than the rate on fixed-rate loans, but there's a risk it will rise above the fixed rate down the road. Currently, the one-year ARM charges 2.75%, the three-year 3.68% and the five-year 3.23%. The 30-year fixed rate averages 4.3%.

ARMs have not been very popular since the financial crisis broke, because fixed rates have been so low. But the five-year ARM has occupied a kind of sweet spot for borrowers who wanted a low rate for five years and didn't worry too much about what happened afterward, either because they could afford a rate hike or didn't expect to stay in the home very long after the initial deal expired.

In April 2012, for example, a five-year loan could be had for 2.5%, versus 4% on the 30-year.

Now that discount isn't as quite so big, about 1 point rather than 1.5, and the other risks look bigger. With the economy and housing market improving, rates are inching up, and the financial markets have been reeling from the recent Federal Reserve suggestion that it could soon start winding down programs to keep rates low.

That increases the prospect that an ARM rate could rise after the initial period ends. ARMs typically limit rate changes to 2 percentage points a year and 6 points over the life of the loan. That means a five-year ARM that starts today at 3.2% could eventually charge more than 9%. Even with the 2-point annual cap, it could go to 5.2% after five years -- a full point higher than you'd be paying at that time if you'd locked in a fixed-rate loan today.

In the past, many ARM borrowers have made the mistake of assuming that if their ARM rate rose they could refinance to a cheaper fixed-rate loan. But rising rates generally affect all types of loans, so if ARM rates rise, it probably would not be possible to get a fixed loan as cheap as you can get today.

As mentioned, the five-year ARM also appealed to borrowers not likely to own their homes very long, which made the risk of future rate hikes irrelevant. This could still be a factor for homeowners confident they could sell without a loss in five or six years, such as a long-term owner who wants to refinance a loan on a home that has lots of equity.

But if you're buying a home now, you cannot be sure you could sell without a loss in five or six years. You need enough time for the home's value to rise enough to offset buying and selling costs such as a real estate agent's commission, transfer taxes, legal fees and loan application charges. Many experts think the pace of annual appreciation, at double digits in many areas during the past year, will slow down to an average of 2% to 3%. That would probably make a five-year break-even on a home purchase possible, but iffy.

It's not hard to imagine that in five years the standard 30-year fixed-rate loan could charge 6% or 7%, a fairly typical rate that ARMs would eventually reach as well after one or two adjustments. If so, a homeowner who had obtained a fixed-rate loan five years earlier would be very happy about paying 4%.

Check Out Our Best Services for Investors

Action Alerts PLUS

Portfolio Manager Jim Cramer and Director of Research Jack Mohr reveal their investment tactics while giving advanced notice before every trade.

Product Features:
  • $2.5+ million portfolio
  • Large-cap and dividend focus
  • Intraday trade alerts from Cramer
Quant Ratings

Access the tool that DOMINATES the Russell 2000 and the S&P 500.

Product Features:
  • Buy, hold, or sell recommendations for over 4,300 stocks
  • Unlimited research reports on your favorite stocks
  • A custom stock screener
Stocks Under $10

David Peltier uncovers low dollar stocks with serious upside potential that are flying under Wall Street's radar.

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
14-Days Free
Only $9.95
14-Days Free
Dividend Stock Advisor

David Peltier identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.

Product Features:
  • Diversified model portfolio of dividend stocks
  • Updates with exact steps to take - BUY, HOLD, SELL
Trifecta Stocks

Every recommendation goes through 3 layers of intense scrutiny—quantitative, fundamental and technical analysis—to maximize profit potential and minimize risk.

Product Features:
  • Model Portfolio
  • Intra Day Trade alerts
  • Access to Quant Ratings
Real Money

More than 30 investing pros with skin in the game give you actionable insight and investment ideas.

Product Features:
  • Access to Jim Cramer's daily blog
  • Intraday commentary and news
  • Real-time trading forums
Only $49.95
14-Days Free
14-Days Free
AAPL $94.27 -0.76%
FB $101.00 1.47%
GOOG $684.12 0.89%
TSLA $143.67 -3.09%
YHOO $27.10 1.04%


Chart of I:DJI
DOW 15,914.74 -99.64 -0.62%
S&P 500 1,851.86 -0.35 -0.02%
NASDAQ 4,283.5920 +14.8290 0.35%

Free Reports

Top Rated Stocks Top Rated Funds Top Rated ETFs