This Day On The Street
Continue to site right-arrow
ADVERTISEMENT
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
TheStreet Open House

Are Adjustable-Rate Mortgages Worth the Risk?

NEW YORK (TheStreet) -- Confounding most predictions, mortgage rates have remained unusually low this year, begging a question: Is an adjustable-rate mortgage worth the risk?

It can be, but it's likely that many borrowers focus on the wrong issue, looking at the way lower interest rates on ARMs (as opposed to fixed-rate loans) reduce monthly payments. Currently, a one-year ARM charges 2.876%, a 30-year fixed-rate loan 4.313%.

A lower payment obviously means more money in your pocket for other things. But if that's what matters to you, consider it a red flag. The ARM rate will start out lower than the fixed-rate loan, but could go higher when the annual adjustments start after one, three, five or seven years. At some point, you could pay more each month than you would if you'd taken out a fixed loan. That means if you think the monthly payment on a fixed loan would be a stretch, be very wary of taking out an ARM for the same amount.

Why, then, would you even consider an ARM? In a nutshell, not to reduce monthly payments but to reduce your overall interest charges -- assuming everything works in your favor.

Also see: This May Be the Time to Buy a Vacation Home

Consider some numbers produced by Jack M. Guttentag, emeritus professor of finance at the Wharton School. On a $300,000 loan, he figured a 30-year fixed mortgage would charge 4%, for a monthly payment of $1,432. A five-year ARM would start at $2.635%, for $1,205 a month.

After five years, the ARM rate would be reset every 12 months, based on a formula using prevailing rates, with a "cap" limiting the annual changes -- typically 2 percentage points for each adjustment, up or down. Assuming the rate went up the maximum allowed, the five-year ARM would still be cheaper than the fixed loan for nine years. It would take that long for the rising payments on the ARM to wipe out the savings enjoyed in the first five years. After the nine-year breakeven point, the total cost of the ARM would be higher than for the fixed loan.

Note that in year six, the ARM would charge about 4.6%, while the borrower would have continued paying just 4% on the fixed loan. In year seven, the ARM could charge 6.6%. So although the total costs of the ARM are still lower through these years, the monthly payment would be considerably higher than on the fixed mortgage.

Also see: How Stagnant Wages Have Trapped the Housing Market

Of course, the borrower could get lucky, with smaller rate hikes. Conceivably, rates could even go down. But if that happened, the savings would be gravy. Unless you have a crystal ball, the prudent move is to assume the rate will go up the maximum allowed.

All this demonstrates that an ARM is a safe bet only if you can afford the maximum payments it could charge, and that overall savings are certain only if you expect to pay off the mortgage before the breakeven point -- by selling the home, for instance. If you expect to have the loan longer than that, savings are a gamble. (Find the breakeven point with the ARM vs. Fixed Rate Mortgage Calculator).

To improve your odds of coming out ahead, the monthly savings from the ARM should be reinvested, not spent. That "extra" cash could be used as extra principal payments to reduce the mortgage balance, thus reducing the payments after subsequent adjustments. Or it could be invested in stocks, bonds or mutual funds -- anything that looks promising.

But if you're considering an ARM because the lower initial payments will make it easier to put food on the table or make your car payment, better reassess. In this case, the key issue is not whether to get an ARM instead of a fixed loan, it's whether you'd be wiser to buy a cheaper home.

Check Out Our Best Services for Investors

Action Alerts PLUS

Jim Cramer and Stephanie Link 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

Jim Cramer's protégé, David Peltier, uncovers low dollar stocks with extraordinary upside potential that are flying under Wall Street's radar.

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
Try it NOW
Try it NOW
Try it NOW

Check Out Our Best Services for Investors

Dividend Stock Advisor

Jim Cramer's protégé, 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
Options Profits

Our options trading pros provide over 100 monthly option trading ideas and strategies to help you become a well-seasoned trader.

Product Features:
  • Actionable options commentary and news
  • Real-time trading community
Try it NOW
Try it NOW
Try it NOW
To begin commenting right away, you can log in below using your Disqus, Facebook, Twitter, OpenID or Yahoo login credentials. Alternatively, you can post a comment as a "guest" just by entering an email address. Your use of the commenting tool is subject to multiple terms of service/use and privacy policies - see here for more details.
Submit an article to us!

Markets

DOW 17,164.95 -251.90 -1.45%
S&P 500 1,994.99 -26.26 -1.30%
NASDAQ 4,635.24 -48.1670 -1.03%

Partners Compare Online Brokers

Free Reports

Free Newsletters from TheStreet

My Subscriptions:

After the Bell

Before the Bell

Booyah! Newsletter

Midday Bell

TheStreet Top 10 Stories

Winners & Losers

Register for Newsletters
Top Rated Stocks Top Rated Funds Top Rated ETFs