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5/5 ARMs: The best ARM money can buy?

 

Craig Olson is never surprised when people call his office to ask about the 5/5 adjustable-rate mortgage loan. As Olson says, the loan combines the certainty of a fixed-rate mortgage and the low initial interest rate of an ARM in one package.

"Anyone who is looking for lower interest rates would be interested in this product," says Olson, senior vice president of Pentagon Federal Credit Union in Omaha, Nebraska. "People want that lower initial interest rate but they also want more security than you usually get with ARMs. That's what attracts people to a 5/5 ARM."

Even with today's low mortgage rates on 30 and 15-year fixed-rate loans, the initial interest rate on a 5/5 ARM is even lower, says Keith Gumbinger, vice president of HSH.com, saying 5/5 rates stood near 3 percent in mid-May.

There's added security, too. A 5/5 ARM works in much the same way as a traditional ARM but with more security built in. In such a loan, your initial interest rate is fixed for the first five years. The 5/5 ARM then resets to a new rate every five years until the loan reaches the end of its 30-year life.

Is a 5/5 ARM right for you?

The answer depends on how prepared you are to pay a higher monthly payment five years from now. Consumers who take out a 5/5 ARM today will be paying a higher interest rate in five years, says Gumbinger.

"I can tell you that with 100 percent certainty," he says. "What I can't tell you is how much higher that rate will be."

And that's the question with all ARMs.

That's why borrowers interested in 5/5 ARMs must make sure they can afford the higher mortgage payments when their loan adjusts.

How to prepare for a rate increase

Gumbinger recommends that borrowers use a mortgage calculator to first run a worst-case scenario. What would happen to your mortgage payment if your rate shot up to 9 percent? Could you afford that monthly payment?

Of course, an interest rate of 9 percent is a worst-case scenario, and an unlikely one. Gumbinger then recommends that borrowers run a more realistic scenario -- a rate adjustment from 3 percent to 6 percent. Could you still afford your monthly payment after that increase?

"If you're afraid you can't afford your loan after the rate adjusts, you probably shouldn't go into a 5/5 ARM no matter how enticing that initial interest rate is," Gumbinger says.

Added security

Certain lenders might offer even more security with their 5/5 ARMs. At Pentagon Federal, for instance, interest rates can only jump a maximum of 2 percentage points following the initial five-year-fixed period, Olson says. As of late May, the credit union was offering an initial interest rate of 3 percent for most borrowers taking out 5/5 ARMs. After the fixed period ends, the highest interest rate borrowers could see is 5 percent. That means you would pay an average interest rate of 4 percent for those first 10 years.

Pentagon Federal also limits the total increase in interest rate to 5 percentage points for the life of the loan, Olson says.

Not everyone is on the ARM bandwagon

Despite the advantages, not all borrowers are interested in ARMs.

Don Frommeyer, president of the National Association of Mortgage Brokers and senior vice president of Amtrust Mortgage Funding in Carmel, Indiana, says that ARMs in general aren't as appealing in parts of the country where home prices are lower.

Frommeyer does much of his lending in the Indianapolis area where his average loan amount is $125,000. Since fixed mortgage rates are already so low - HSH.com reports that the average interest rate on a 30-year fixed-rate mortgage was 4.25 percent as of mid-May -- borrowers who take out smaller loan amounts won't realize much month savings by taking out a 5/5 ARM.

"I think you'll see more interest in places like California or the East Coast where loan amounts are higher," Frommeyer says. "In those markets, a difference of 1 percent means a whole lot of money. It doesn't mean as much when your loan amount is $125,000."

Refinancing?

For those with larger loan amounts refinancing to 5/5 ARMs, a rate reduction of 1 percent or more can have a big financial impact, Gumbinger says.

"The benefits can be appreciable. You can get considerable payment relief."

About the author:

Dan Rafter has written about mortgage lending for more than 15 years. He's written for the Chicago Tribune, Washington Post, Consumers Digest, BusinessWeek Online and others.