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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%.

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