Editor’s note: This is the second of a three-part series.

Adjustable-rate mortgages (ARMs) are only about 10 percent of the market today, yet I would guess that perhaps half of all new borrowers would select an ARM if they understood them. Fear of the unknown and the risks associated with the unknown generate a safety-first knee-jerk, which is to retreat to the fixed-rate mortgage (FRM) that has no interest-rate risk.

On May 27, the zero-fee rate on a 7/1 ARM was 3.375 percent, or 1 percent lower than the rate on a zero-fee 30-year FRM. This translates into a monthly payment difference of \$57 per \$100,000 of loan amount. Over the seven years for which the initial ARM rate holds, the cost to the ARM borrower relative to the FRM borrower would be more than \$7,000 less per \$100,000 of loan amount. That is a significant benefit.

The risk to ARM borrowers is that they will still be in their house after seven years, and that the rate and payment will increase. But the risk on an ARM can be measured and understood. Borrowers who take the trouble to do that may decide that the risk is too large to justify the benefit. Or they may decide that the risk is worth taking.

The borrower taking an ARM can reduce the risk by making the larger FRM payment. The larger payment results in a larger balance reduction, which reduces the payment increase following a rate increase.

Step 1 is to quantify the risk of taking the ARM. I do this by first defining alternative scenarios for future interest rates. Then, for each rate scenario, I calculate both the highest future payment and the total cost relative to that of the comparable FRM. Cost is calculated in the two cases where the ARM borrower makes the ARM payment or makes the FRM payment. The table shows results for the 7/1 ARM and FRM described above. Positive numbers in the table indicate that the borrower would benefit from a cost standpoint taking the ARM rather than the FRM.

Monthly Payment and Total Cost of 7/1 ARM and 30-Year FRM Under Different Interest Rate Scenarios, Priced on May 26, 2011

 Assumption About Future Interest Rates No-Change Small Increase Moderate Increase Large Increase Worst Case Monthly Payment FRM 499.29 499.29 499.29 499.29 499.29 ARM 1- 84 442.10 442.10 442.10 442.10 442.10 ARM 85-360 424.98 492.92 566.31 671.90 693.43 Total FRM Cost Less Total ARM Cost Per \$100,000 of Loan 7/ARM Pmt 7,158 7,158 7,158 7,158 7,158 7/FRM Pmt 7,406 7,406 7,406 7,406 7,406 8/ARM Pmt 8,527 7,256 5,980 4,279 3,940 8/FRM Pmt 8,849 7,659 6,459 4,861 4,549 9/ARM Pmt 9,895 7,357 4,798 1,360 687 9/FRM Pmt 10,293 7,916 5,497 2,279 1,649 10/ARM Pmt 11,261 7,461 3,612 -1,578 -2, 596 10/FRM Pmt 11,748 8,187 4,532 -327 -1,280 11/ARM Pmt 12,638 7,567 2,425 -4,536 -5905 11/FRM Pmt 13,211 8,474 3,564 -2,953 -4,234

Note: Total cost is total payments plus interest loss on such payments calculated at 2 percent, less reduction in the loan balance.

The results in this case indicate that even in a worst-case interest-rate scenario, where the rate increases by the maximum allowed by the ARM contract, the borrower is better off with the ARM if he is out within nine years. If rates increase only moderately, defined as an increase of 0.75 percent a year for four years starting after the first year, the borrower is better off with the ARM even staying as long as 13 years. In both cases, however, the borrower must feel comfortable with the payment increase he will face if rates increase and he still has the mortgage after seven years.

My general though much oversimplified rule: If total ARM cost is less than total FRM cost on a worst-case scenario over the period, that is your best guess as to how long you will be in the house, and if you believe you could meet the worst-case payment if necessary, select the ARM. If total ARM cost is greater than total FRM cost, or if you fear you would not be able to deal with the worst-case payment, select the FRM.

Note: The cost data in the table are derived from ARM Tables Tutorial on my website, and the payments are from my calculator 7b.

In next week’s article, I suggest that many borrowers in today’s market are making a mistake in selecting the combination of interest rate and points that would best meet their needs.

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