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.