Editor’s note: This is Part 1 of a two-part series. Read Part 2 here.

One of the most critical decisions mortgage shoppers must make is the type of mortgage that best meets their needs. The importance of the decision has been heightened by a post-crisis market in which price differences between all categories of mortgages are unusually large.

The decision process can be divided into three parts: The first is whether to select an adjustable-rate mortgage (ARM) or a fixed-rate mortgage (FRM). All ARMs today are 30 years, and in this article we compare them to a 30-year FRM.

The second part of the decision process, for those who elect the FRM over the ARMs, is to select the term of the FRM.

The third part is to decide whether or not to take an interest-only payment option. Parts two and three are the subject of next week’s article.

FRMs offer borrowers interest rate and payment stability. This is particularly advantageous to borrowers who are not sure how long they will have their mortgage, and who find the FRM payment affordable. ARMs offer borrowers a lower interest rate and payment in the early years, which is particularly advantageous to borrowers who know about how long they will have their mortgage. ARMs also work for borrowers who require the lower initial rate to make the initial payment affordable, and can handle the risk of rising payments in the future.

Taking account of price differences: Borrowers should take account of the price differences between FRMs and ARMs in deciding between them. If there is no or little price difference, there is no good reason to select an ARM.

This was the case when I last addressed the issue in 2006. On Oct. 8 of that year, I shopped for a $320,000 loan on a $400,000 single-family home in California to a borrower with excellent credit and adequate documented income. The market at that time offered this borrower a 30-year FRM at 6 percent and zero points, and a 3/1 ARM at 5.75 percent and zero points. The 5.75 percent rate held for only three years, after which the rate adjusted every year.

My conclusion at the time was that the 0.25 percent price difference between the FRM and the 3/1 ARM was not large enough to justify the price risk on the ARM — with the possible exception of borrowers who confidently expected to be out of their house within three years. ARMs with initial-rate periods of five, seven and 10 years were priced between the FRM and the 3/1 ARM, making them even less attractive. …CONTINUED

Today, the price differences are much larger and ARMs are correspondingly more attractive. On Jan. 8, 2010, I shopped the same loans described above. The 30-year FRM was 5.125 percent and the 3/1, 5/1, 7/1 and 10/1 ARMs were 4 percent, 4.125 percent, 4.5 percent and 4.875 percent, respectively. The borrower taking the 3/1 ARM rather than the FRM now saves 1.125 percent in rate rather than 0.25 percent. Note that while market prices change every day, the price differences between FRMs and ARMs are relatively stable in the short run.

ARM borrowers with short time horizons: When the pricing is advantageous, the most logical candidate for an ARM is the borrower who expects to be out of the house before the initial-rate period is over. While few borrowers can be certain about this — life sometimes confounds our best plans — the rate savings should substantially outweigh the risk of being caught by a rate adjustment. If you expect to be out within three, five, seven or 10 years, select a 3/1, 5/1, 7/1 or 10/1 ARM, as the case may be.

ARM borrowers who need the lower initial payment: A second reason to select an ARM is the lower initial payment associated with the lower initial rate. In some cases, the borrower needs the ARM in order to meet the lender’s underwriting requirements, which include maximum ratios of mortgage payment and other expenses to borrower income. In other cases, borrowers need the ARM to meet their own views of what constitutes an affordable payment.

Borrowers who select an ARM because they need the lower payment assume the risk of a possible rate and payment increase at the end of the initial-rate period. Borrowers faced with this decision should ask themselves: "Is this a risk worth taking" and "Can I afford to take it?"

The best way I know to deal with these questions is by determining what will happen to the rate and payment on the ARM if market interest rates change in ways that the borrower specifies. This "scenario analysis" provides a measure of the risk if rates increase, and the benefit if they don’t. It also allows borrowers to determine the extent to which they can reduce the risk on the ARM by making the larger payment that they would have made had they selected the FRM.

To do a scenario analysis, you must know all the features of the ARM that affect future rates and payments: the rate index used by the ARM; its current value; rate adjustment caps; and the lifetime maximum rate. You should have this information anyway; otherwise, you don’t know whether you have found the best deal on your ARM.

Readers who want to do a scenario analysis on an ARM will find an explanation of how to do it, with an example, on my Web site in Choosing Between Adjustable and Fixed Rate Mortgages.

The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.


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