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The Case Against Adjustable Mortgages

By Peter McDougall

Few prospective homeowners should be considering adjustable-rate mortgages (ARMs) these days.

As recently as three years ago, ARMs accounted for nearly 28% of all new mortgage applications. Nowadays, the share is less than 2%, according to the Mortgage Bankers Association. In the past, homeowners flocked to ARMs because initial interest rates were lower than those on comparable fixed-rate mortgages (FRMs). But as mortgage rates have tumbled steadily in recent months, that is no longer the case.

Here's why you shouldn't be considering an ARM right now.

The interest rates: The national average for a 30-year FRM is currently 5.26%, according to The national average for a 5/1-year ARM is 6.01%. (A 5/1-year ARM is one of the more common forms of hybrid ARMs where the rate is fixed for the first five years, then adjusts each subsequent year.) Rate offers will vary widely in a given region, but on the whole, rates on FRMs are very close to those on ARMs.

For instance, in the New York metropolitan area, offers on 30-year FRMs include a 4.875% rate with 0.5 points from Wachovia (WB) , a 5.0% rate with no points from HSBC (HBC) and a 5.0% rate with no points from Webster Bank (WBS). (Points are a way to lower the interest rate on your loan. One point usually costs 1% of your loan and lowers your rate by 0.125%.)

Compare those FRM offers to 5/1-year ARM offers from the same institutions: 4.75% with 0.125 points from Wachovia, 5.625% with no points from HSBC and 4.75% from Webster Bank. There is often only a fraction of a percentage point difference between the rates of the two loan types.

The APRs: While rates on FRMs may be lower than rates on ARMs, that is not necessarily the case with the measuring stick of mortgages -- the annual percentage rate, or APR. The APR on an FRM includes the cost of the fees charged by your lender -- such as origination fees and the cost of an appraisal of your home -- so the APR is almost always higher than the loan’s offered interest rate. When calculating an APR on an ARM, however, the lender must take into account what happens when the rate adjusts in the future.

For that reason, don't get too excited about a low APR on an ARM. Under normal circumstances, the rate on an ARM would adjust upwards, leading to an APR higher than the listed interest rate. Due to current market conditions, however, rates on ARMs would actually adjust lower, as indicated by an APR that is lower than the offered interest rate. (This is the case with a JPMorgan Chase (JPM) offer in the New York area, where the interest rate is 5.875% but the APR is only 4.054%.) And bear in mind that the APR will change. The lower APR only reflects current conditions, not necessarily what will happen five years in the future when your first rate adjustment occurs.

The risks: FRMs mean your rate is locked in for the life of your loan -- not so with ARMs. After five years, the rate on a 5/1-year ARM will adjust to whatever market conditions dictate, though most ARMs limit how high the rate can rise each year. That means in five years, your monthly payments will likely change. While you may plan on refinancing or selling your home to avoid the rate adjustment, be aware that many homeowners got caught using a similar strategy when home prices fell over the past few years, leaving them owing more than their home was worth. Fact is, given the uncertainty in the real estate market and the historically low interest rates on FRMs, ARMs still offer plenty of risks without many of the traditional benefits.

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