In February, Get Rich Slowly reader Abby wrote with questions about her adjustable-rate mortgage (or ARM, for short). She’s had an ARM for seven years now, and the rate is due to reset in 2010. She wants to know what her best course of action is. Abby writes:

In Fall 2003, I began my career as a teacher and bought my first house at 23. I shopped around for a home loan, borrowing a little over $111,000. I had good credit and picked a 7-year ARM at 6.125%. At the time, I planned to work in the City Schools for five years — so that my student loans would be forgiven. I thought that by the 7-year mark I’d be moving to a new area (back home) or be ready for a different house. Oh, how hindsight is 20/20.

I’ve moved forward in my career and am enjoying my house. I have other debts that I’m aggressively trying to pay down. In December of this year, my interest rate will adjust. The rate will adjust based on the “Index” (which, according to my paperwork, is the weekly average yield on US Treasury securities adjusted to a constant maturity of one year) with a margin of 3.410%.

With the rates being what they are, I was considering refinancing. I’ve contacted some places and, with my now excellent credit rating, I qualify for some lower 30-year mortgages, but it’s the closing costs that confuse me. My mortgage payment is about $925 a month, which makes my break-even point several years away. I know that I’ll want to continue building my career, but I imagine that I will begin to outgrow this house in the next few years.

To finally get to the question: Is it reasonable to believe that I could actually benefit from the ARM with the current low rates and that my rate could stay about the same or even lower? What are your thoughts on adjustable-rate mortgages with the rates so low?

My thoughts are: This question is way out of my league. I know there are a lot of folks who have adjustable-rate mortgages, but I’m not one of them. I have no experience with them, and I’m only vaguely familiar with the implications. To get some solid answers to Abby’s questions, I asked Tim Manni from HSH.com if he could talk about the pros and cons of adjustable-rate mortgages. Everything that follows (except the questions at the end) comes from Tim.

Are adjustable-rate mortgages evil?
Despite being around for over 25 years, adjustable-rate mortgages (ARMs) have recently begun to lose their favor in the mortgage market. There are at least a couple reasons why ARMs aren’t as popular as they once were: The housing crisis has scared many borrowers away from any home-loan product without a fixed rate, and ARMs have gotten a bad rap because they’ve been associated with other riskier mortgages like loans made to sub-prime borrowers, pay-option schemes, and no-documentation products.

While it’s true that hundreds of thousands of borrowers — who likely couldn’t properly afford an ARM in the first place — entered into default because their monthly payments increased when the rate on their ARM reset higher, ARMs certainly aren’t “evil” or “toxic”, if used correctly. While ARMs aren’t very popular at the moment, they can still be used to a homebuyer’s advantage, even in today’s low-rate market.

How do ARMs work?
ARMs start with a fixed rate for a period — sometimes as short as three months or as long as 10 years. Thereafter, the rate is tied to an economic indicator, called an Index, which governs changes in your loan’s interest rate and, thus, your payments. When the ARM rate is adjusted, the lender (or servicer) uses the value of the Index, and adds a markup, known as a Margin. (Abby’s Margin is 3.410%.) Generally, the total of your Index plus Margin equals the interest rate you’ll be charged for the next fixed period, however long that may be (just one year in Abby’s case). Such interest rate changes are governed by limits, called caps.

ARMs when rates are high(er)
Abby purchased her home back in 2003 using a 7/1 ARM (a home loan with a fixed rate for the first seven years, with the interest rate adjusting every year thereafter). At that time, the combination of current mortgage rates and Abby’s uncertain living situation made her a prime candidate for an ARM. A fixed rate for seven years was all the “fixed-rate mortgage” she needed, and it came at a better price than loans fixed for a full 30 years.

When Abby purchased her home in the fall of 2003, 7/1 ARM rates were lower than the 30-year fixed rates. ARMs were developed in a time when fixed-rate mortgages (FRMs) were extremely expensive. Rates were well into the double digits in the early 1980s, and few borrowers were interested in locking in those high rates for a full 30 years, even if they could qualify for them.

J.D.’s note: HSH.com has a cool feature that lets to you compare mortgage-rate trends all the way back to the 1980s, but it’s probably only of interest to numbers geeks like me.

The combination of Abby’s temporary living situation and the lower mortgage rate allowed her to benefit immensely from the ARM.

Things change
Abby is now the final year of the fixed-rate portion of her ARM, and is still living in her original home with plans to stay there (at least for a little while longer). With her ARM due to reset in December of this year, Abby wants to know whether or not she should stay with her ARM given how low current mortgage rates are.

Abby also asks this question because, if her ARM resets today, her new interest rate for the next year would be in the neighborhood of 4%. This (combined with her now seven-year-lower loan balance) will give her a new monthly payment substantially less than she now has — a powerful reason to consider holding onto her present loan.

ARMs when rates are low(er)
One could argue that Abby has already maximized the benefits she could get out of her current mortgage. To avoid future uncertainty about living arrangements and market conditions, and to take advantage of an even lower mortgage rate than what she has now, Abby could simply refinance her ARM to a fixed-rate product before her December reset.

When interest rates are low — at or close to historical lows (as they have been for the last year or so) — the only way rates can be expected to move is upward. By refinancing her ARM relatively soon, Abby can lock in a low, fixed-rate mortgage rate for up to the next 30 years.

Abby’s current mortgage rate is 6.125%. If she decides to refinance into a new 7/1 ARM before December, chances are her interest rate will be in the 5%-5.25% range. Abby could get rid of all the uncertainty about future rate resets by meeting herself in middle with a fixed-rate loan, currently hovering in the lower 5% range.

If Abby decides to stick with her original ARM (without refinancing), she has to ask herself whether or not she can handle an appreciable increase in her interest rate at some point down the road. Could she handle her monthly payments if her interest rate doubled? Is she prepared to potentially dedicate her savings to her mortgage if rates jump?

Final thoughts
While Abby was the perfect candidate for an ARM back when she originated her loan, she has the chance to remove all uncertainty surrounding future rate increases — even living arrangements — by refinancing to a fixed-rate loan.

If you find yourself in Abby’s situation you need to answer these questions:

  • How long do you plan on being in your home?
  • What are the risks of remaining in your ARM?
  • If you decide to refinance today — relative to market conditions — is it a valuable choice?

What do you think? Do you have an adjustable-rate mortgage? Have you had one in the past? When does it make sense to keep an ARM, and when does it make sense to refinance at a fixed rate? What would you do if you were Abby?

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