NEW YORK (MainStreet) — For the past year or so, the five-year adjustable-rate mortgage has been an appealing alternative to the standard 30-year fixed-rate loan. Now there’s another good option on the mortgage market: the seven-year ARM.
In most surveys, seven-year ARMs offer rates almost as low as five-year ARMs, so is it worth paying a tad more to lock a low rate in for an extra two years? For borrowers who don’t expect to stay in their homes for the long term but also don’t plan on moving in the next few years, it may be.
Five- and seven-year ARMs offer a low rate for the initial period, after which the rate adjusts up or down with market conditions, typically every year but sometimes at longer intervals, until the loan is paid off.
The BankingMyWay Mortgage rate search tool shows the cheapest seven-year ARMs charging around 2.625% in interest for the first seven years, compared to 2.5% for the best five-year ARMs. A survey by The Mortgage Professor puts the national averages at 2.747% for the seven-year loan, and 2.333% for the five-year loan.
For the initial period, ARMs offer significant savings over the 30-year fixed loan, averaging 4.223% in the BankingMyWay survey and 2.772% in the Mortgage Professor’s survey. (Differences involve factors such as how points are counted.)
Let’s say you could get a five-year deal at 2.3% and the seven-year one at 2.75%. How would you choose?
In the past, many ARM borrowers figured they could refinance to a fixed-rate loan if future ARM adjustments raised rates too high, but refinancing is not a safe bet today because it’s very unlikely future rates will be as low as they are now. So the borrower who expects to stay in the home for 15, 20 or 30 years will most likely do best locking in a 30-year rate, as an ARM could well charge much more after future resets.
The homeowner who is very likely to move in five years or less is clearly better off with the five-year ARM, getting the lowest possible rate without facing the risk of having to pay a higher rate after five years. That leaves homeowners in between – those likely to move after five to 10 years. Consider what would happen if rates on each ARM moved up 2 percentage points after the initial period, then stayed at the higher level until the home was sold after 10 years.
With the five-year loan, monthly payments on every $100,000 borrowed would be $384.80 in the first five years and $477.74 in the remaining five, for a total cost of $51,752 over 10 years.
With the seven-year deal, the homeowner would pay $408.24 a month for seven years and $504.53 a month for the next three, for a total of $52,435. After 10 years, that’s only $683 more than with the five-year loan at the lower rate. In this case, the five-year deal is a tiny bit cheaper, but many homeowners would value the peace of mind of locking in a rate for seven years instead of five.
Of course, the appeal of each loan would change if one made different assumptions about future rate resets. If you thought rates would stay very low, the five-year deal would probably be cheaper, while the seven-year loan might well pay off if you expect rates to jump. If rates were to rise a lot, neither ARM would beat the 30-year fixed loan.
So the key is to play with the calculator to explore best- and worst-case scenarios for the period you are likely to have the home. Be sure to know the terms for each loan’s adjustments, including caps on annual and lifetime rate changes.
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