NEW YORK (MainStreet) — Some homeowners are choosing adjustable rate mortgages instead of the traditional 30-year mortgages to take advantage of lower interest rates for several years.

The biggest benefit of an ARM is that they have lower interest rates than the more common 30-year fixed rate mortgage. Many ARMs are called a 5/1 or 7/1, which means that they are fixed at the introductory interest rate for five or seven years and then readjust every year after that, said David Reiss, a law professor at Brooklyn Law School. The new rate is based on an index, perhaps LIBOR, as well as a margin on top of that index.

The main disadvantage is that the rate is not fixed for as long as the interest rate of a 30-year fixed rate mortgage, but younger homeowners may not consider that a negative factor.

Younger Owners Should Consider ARMs

While many homeowners gravitate toward a 30-year mortgage, younger owners “should seriously consider getting an ARM if they think that they might move sooner rather than later,” he said. If you are single and buying a one-bedroom condo, it is likely you could enter into a long-term relationship and have kids.

“That person might not want to pay for the long-term safety of a 30-year fixed rate mortgage and instead save money with a 7/1 ARM,” Reiss said.

The 30-year fixed mortgage rate is 3.50% as of April 7 while a 5/1 ARM is 2.83% as of April 7, according to Bankrate’s national survey of large lenders.

Interest Rates Are Capped

While ARMs expose the borrower to rising interest rates, they typically come with some protection. Interest rates often cannot rise more than a certain amount from year to year, and there is also typically a cap in the increase of interest rates over the life of the loan, said Reiss. During the height of the housing boom, lenders were originating 1/1 ARMs that reset after the first year, but now they reset frequently after the fifth and seventh year.

An ARM might have a two-point cap for one-year increases; that means, an introductory rate of 4% could only increase to 6% tops in the sixth year of a 5/1 ARM, Reiss said. That ARM might have a six-point cap over the life of the loan, which means a 4% introductory rate can go to no higher than 10% over the life of the loan.

Determining what the caps are in the ARM are critical, said Staci Titsworth, regional manager of PNC Mortgage in Pittsburgh. There are annual caps and life caps. An annual cap protects the customer from having his rate go higher than the capped rate when interest rates are rising. The life cap protects homeowners for a worst case scenario for the maximum rate for the life of the loan. A typical annual cap may be 2%, and a lifetime cap may be 6% or even 5% on longer term ARMs for five and seven years.

When rates decline, customers can benefit from a lower rate at the time of the adjustment. Some lenders offer "interest only" ARMs which feature lower payments, allowing for more available funds for other necessities, she said.

In periods of prolonged low interest rates, such as the past few years, consumers have clearly benefited from utilizing adjustable rate mortgages, said Joseph Cahoon, director of the Folsom Institute for Real Estate at Southern Methodist University’s Cox School of Business. The difference between the interest rates of the longer fixed-rate loans and adjustable rate mortgages have narrowed compared to the past.

Lower Monthly Payments

It remains to be seen if there are signs of a comeback, but many borrowers view ARMs as a way to save money, said Michael Moskowitz, president of Equity Now, a direct mortgage lender based in New York.

“Now there are signs that ARMs , which faded out of sight a few years ago, may be achieving a new life of sorts,” he said.

Budget for New Rate Increase

Potential homeowners need to consider whether they can make the newer payments once the new rate starts to avoid the possibility of making late payments or even worse, foreclosing on the home.

The benefits of an ARM usually outweigh the disadvantages. If you obtain a five-year ARM and the rate starts adjusting up to its highest point on day one of the sixth year, you will still have the five years of savings, Josh Moffitt, president of Silverton Mortgage Specialists in Atlanta.

“If it’s unlikely that you’ll stay in the home for more than six years, the five-year ARM is still a good product, because you saved yourself thousands of dollars in interest,” he said. “There’s usually not a right or wrong in deciding on an ARM.”

People who are buying their first home often tend to live there for a shorter period, which makes ARMs an attractive option, Moffitt said. Homeowners need to be prepared and should budget for the increase in monthly payments, so if worrying about the adjustment keeps you up at night, the savings might not be worth it on a personal level, he said.

Once the adjustable period is up, the rate will move according to the market, which presents a degree of uncertainty, Moffitt said. If you do a five-year ARM and wind up staying in the home for eight years and the rates go up, you might regret not opting for a fixed-rate mortgage.

“You don’t want to be forced into selling your house because of rising rates,” he said. “If you sell your house right on the seven years and save big during your initial rate period, then you might think you’re a financial wizard. If you’re there for ten years, you might regret not choosing a fixed-rate.”

--Written by Ellen Chang for MainStreet