With the housing market seeing signs of a double dip in prices, homeowners who got in over their heads have looked to save money by any means necessary. Now, thanks to extremely low interest rates, adjustable-rate mortgages are luring borrowers away from locking in rates with longer-term fixed mortgages. Although you can score from savings in the short run, choosing an ARM over a fixed-rate mortgage could prove to be a big mistake in the long run.
Low and lower
When it comes to mortgages, homebuyers have never had it so good. After a brief spike earlier this year, rates on 30-year fixed mortgages have headed down again, falling below the 4.5% level. That’s not quite as low as we saw in 2010, but it’s still historically quite attractive.
But for those willing to take on interest rate risk, adjustable-rate mortgages have rates that are even lower. With one-year ARM rates approaching 3%, the difference of 1.5 percentage points represents $250 a month in lower interest on a $200,000 mortgage. HSH Associates reports that the rate difference between ARMs that reset after five years and fixed mortgages is as wide as it’s been since the heart of the housing boom in 2003.
Should you follow the REITs?
In many ways, choosing an ARM over a fixed-rate mortgage is similar to what mortgage REITs Annaly Capital (NYSE: NLY – News), Chimera Investment (NYSE: CIM – News), and American Capital Agency (Nasdaq: AGNC – News) have done to generate such huge profits in recent years. Essentially, taking out an ARM gives you the benefit of borrowing at lower short-term rates, in exchange for a long-term obligation — in this case, owning your home. That has worked well in this rate environment, because short-term rates have stayed at rock-bottom levels for so long.
Similarly, ARM borrowers will enjoy cheap interest payments as long as rates remain low. The risk that they share with mortgage REITs, though, is that if short-term rates spike upward, your borrowing costs will skyrocket. That got many borrowers in trouble during the housing boom, as homeowners discovered that they really couldn’t afford to make mortgage payments once rates returned to normal levels.
A bad reputation
The fact that borrowers used ARMs as the only possible way to afford buying homes gave these loans their bad reputation during the initial part of the housing bust. Option ARMs with negative amortization offered homeowners deceptively cheap payments that were set to balloon upward a few years later. And while some banks, including Wells Fargo (NYSE: WFC – News) and US Bancorp (NYSE: USB – News), didn’t originate option ARMs themselves, plenty of now-vanished lenders, including Countrywide, Wachovia, and Washington Mutual, did. So now, Countrywide-acquirer Bank of America (NYSE: BAC – News), Wachovia-buyer Wells Fargo, and WaMu asset purchaser JPMorgan Chase (NYSE: JPM – News) have ended up with plenty of option ARMs.
As it turned out, interest rates have stayed low throughout the initial period of option-ARM resets, saving many borrowers from the possibility of much higher payments. But eventually, interest rates will go up. And while fixed-rate mortgage borrowers will enjoy their current low-ish rate as long as they own their homes, ARM borrowers may well find themselves in the uncomfortable position of trying to figure out whether to eat much higher interest charges, or refinance into a fixed-rate mortgage at a higher rate than the ones now available.
Middle of the road?
One middle-ground solution between a pure ARM and a fixed mortgage is to consider ARMs that let you lock in your rate for longer periods of time. ARMs with five- or even seven-year fixed periods can give you a discount to fixed mortgage rates, and if you end up moving or refinancing before then — or if you’re able to pay off a significant part of your debt — then the savings is yours to keep.
Saving money on interest charges is always an attractive way to cut costs. But with ARMs, what you get now could cost you later. Whether you can save using an ARM over a fixed mortgage depends on your own personal situation, but one thing is certain: ARMs aren’t a no-brainer smart move for everyone, and they could end up being a big mistake.
Fool contributor Dan Caplinger replaced his mortgage with a low-rate home equity line of credit and has never been happier. He owns shares of Chimera Investment. The Motley Fool owns shares of JPMorgan Chase, Annaly Capital, Chimera Investment, and Wells Fargo. The Fool also owns shares of and has opened a short position on Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool’s disclosure policy always thinks long term.