REAL ESTATE WATCH: Adjustable mortgage's risks and rewards

By bankrate.com Published:

Even with mortgage rates near historic lows, not everyone gets a 30-year fixed-rate loan.

Some homeowners choose adjustable-rate mortgages, or ARMs.

ARMs have both rewards and risks.

Among the rewards: lower interest rates and lower initial monthly payments, notes Gilles Gade, CEO of Cross River Bank in Teaneck, N.J.

Rates on 5-1 ARMs recently have been about 1 percentage point lower than on 30-year fixed-rate loans, which can mean a significant savings in the first few years of the loan, he said.

"Homeowners pay less for their mortgage and at the same time fulfill the dream of owning a new house," he said.

Chief among the risks: Interest rates can go up. If interest rates rise, mortgage payments would rise.

"The number one risk is interest rate risk, where the interest rate can go up over time," said Gibran Nicholas, CEO of CMPS Institute, a national organization that certifies mortgage brokers and bankers in Ann Arbor, Mich.

With rates near historic lows in mid-2012, they are likely to be higher when ARMs reset, he said.

If you're considering financing with an ARM, make sure the mortgage suits your situation and that you understand the rewards and risks.

Homeowners who know they will move in a few years -- perhaps within five or 10 -- should consider ARMs, Nicholas said.

"If you have a 5-1 ARM or 7-1 ARM and you plan to be out of the house before the five or seven years is up, then it could make sense to get the loan and the lower payments," Nicholas said.

However, buyers should prepare to stay in their home longer than they planned, in case circumstances change, he adds.

If you hope to move within three or four years, consider borrowing with a 5/1 ARM, which resets in five years, instead of a 3/1 ARM, which has a shorter fixed-rate period, Nicholas said.

"Give yourself a little bit of time in case the market doesn't cooperate when you're ready to sell your home," he said.

ARMs could also be a solution for borrowers needing a lower payment today but expecting big pay raises within a few years, said Bill Hammer, a Certified Financial Planner in Melville, N.Y.

"If you think your earnings will increase dramatically in the next three or four years but you need the extra cash flow for expenses right now, I think an ARM tends to be a nice solution."

But if the bump in pay doesn't materialize, the borrower could be stuck with hard-to-afford mortgage payments after the rate resets, he said.

Homeowners who need to borrow large amounts of money may have to take out jumbo loans -- mortgages that are too big to conform to Fannie Mae and Freddie Mac guidelines.

In much of the country, a jumbo loan is a mortgage of more than $417,000- that amount is higher in high-cost housing markets, topping out at $729,750.

Jumbo mortgages have higher rates, so borrowers may consider ARMs as an alternative, Nicholas said.

"They can allow you to get a lower rate than with a fixed, nonconforming mortgage," he said. The risk, again, is that rates could be higher when the loan resets, Nicholas said.

However, if the homeowner saves enough money while building equity, it might be possible to do a "cash-in refi" in the future.

The homeowner partially pays down the mortgage -- enough so that the remaining balance can be refinanced with a conforming loan.

It's a neat balance between rewards and risks.

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