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ARMs Still Have Their Place

NEW YORK (TheStreet) -- Adjustable-rate mortgages have been in Siberia for a few years, accounting for only a smidgen of new loans. But certain borrowers should now take a look, as ARMs currently charge significantly less than loans with fixed rates.

Just before the start of the financial crisis in 2007, the three-year ARM rate was about 6%, nearly identical to the rates on 30-year fixed-rate loans. Though the spread widened somewhat as rates fell in the years that followed, fixed-rate loans charged so little that the vast majority of borrowers chose their predictability over the risk of future rate increases they faced with adjustable-rate loans. ARMs typically reset every year after the initial period ends.

But things have changed. In November 2012, the average 30-year fixed loan charged 3.66% and the 3/1 charged ARM 3%. That 0.66-point gap has since widened to 1.5 points, with the fixed loan at 4.6% versus the ARM's 3.1%. For every $100,000 borrowed, the fixed loan would charge $513 a month, the ARM $427.

The ARM would save the borrower nearly $3,100 during the three years its rate was guaranteed, or $9,300 on a $300,000 loan. That's enough to get you thinking.

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Also, the lower rate would allow more of each ARM payment to go to principal, so that after three years the balance on the $100,000 loan would be $94,645, versus $95,109 on the fixed loan.

There is, of course, the standard downside of ARMs: the risk that the annual rate resets that start after three years would leave the borrower paying more than with the fixed loan. For the fourth and fifth year, higher ARM payments might merely erase some of the first three years' savings, but eventually the net cost of the ARM could well be higher. The bigger the rate hike, the sooner that would happen.

So ARMs are best for two groups of borrowers, first being those who don't expect to have their loans for very long -- say only four, five or six years. The upfront savings are guaranteed, the long-term risk removed by the short time horizon.

These may be borrowers who are transferred frequently or expect to trade up as their income or family gets bigger. Now that home prices are again rising, a short-term homeownership plan is not as risky as when they were flat or falling, because there's a better chance of selling the property for enough to pay off the loan balance.

The second group who might consider ARMs includes homeowners who can afford the interest-rate risk and believe resets will keep the mortgage rate low or make it lower. For now, that seems like a stretch, as it would be hard for resets to stay below the historically low 4.6% you can lock in with today's fixed-rate loans. ARMs reset by adding a margin, or number of percentage points, to an index, a widely used gauge of prevailing interest rates. Before getting an ARM, be sure to understand how this calculation will be done.

Also be sure to understand how "caps" would govern the ARM's maximum annual and lifetime rate increases. Get one only if you believe you could handle the largest possible payment increase.

Most borrowers will undoubtedly do best with a fixed-rate loan, locking in today's still-low rate for the long term. But ARMs do have their place, if you'll be a short-term borrower or have a stomach for risk.

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