Question: We have been renting for a long time and have finally decided to buy a house. We've been doing our homework and can easily afford a 20 percent down payment to avoid private mortgage insurance. There's one guy in my office who tells me I should look into adjustable rate mortgages because they are very low. I thought fixed rates were low. Can you tell me if it would be wise to take out a variable rate instead of a fixed?

Answer: Relatively speaking, all rates are low right now - Adjustable Rate Mortgages (ARMs) and fixed rates. But let's talk about ARMs. It's important to know how they work and for whom they're appropriate.

Fixed rate loans carry a higher rate because the burden of interest rate risk is on the lender. If a lender offers a fixed rate at seven percent for 30 years, it receives seven percent, regardless of where interest rates may go. If rates jump to nine percent, the lender is stuck with the seven percent loan when all new loans are paying nine percent. They effectively lose money. The borrower, on the other hand, is happy he locked in because he's paying two percent below market.

Adjustable Rates put the interest rate risk on the borrower. If rates go up in the future, an ARM will adjust along with the market. Because the rate can increase, the borrower absorbs the risk.

It's all about risk and return, folks. The less risky the loan, the higher the rate. The higher the risk, the lower the rate. Let me use a few examples.

Today, a one year ARM might run 4.50 percent. That's pretty cheap. The only problem is that the rate can increase annually. So depending on where rates are in a year, the 4.50% could vanish.

A 3/1 ARM is fixed for the first three years before it can move. Expect to pay something close to five percent - this rate is fixed for the first three years so it's a bit higher. It adjusts annually thereafter.

"Risk and return".

The borrower will pay a bit more to take a loan that carries less risk. He now has three years of interest rate stability instead of one.

And so the story goes. Expect to pay something close to 5.50 percent for a 5/1 ARM. A little bit higher, but now you have five years without having to worry about your rate increasing. A 7/1 ARM might be six percent and a 30 year fixed rate -- with no interest rate risk -- will cost you about 6.50 percent.

ARMs are great deals for the right sort of person. For example, if you are pretty sure you will sell your home within five years, a 5/1 ARM is perfect. You don't need the extra 25 years of rate security so why take out a 30 year fixed rate loan? Other people take out ARMs because they like the low rates and are not terribly worried about interest rates going through the ceiling.

My advice to you is to consult with a good loan officer and have him lay out the menu of mortgage products. Compare the rates and monthly payments. This will allow you to choose the right product that meets your objectives.

Published: June 26, 2002

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