Adjustable rate mortgages can become costly

By SCOTT HANSON MONEY MATTERS 09-NOV-05 How many of you would buy or lease a car without knowing what your payments would be? Can you imagine a car dealer telling you that your car payment would be $500 for the first six months, but he had no way of knowing what it would be after that? I doubt there would be many takers on a deal like that. As ridiculous as this may seem, this is exactly what many homeowners are doing with their home mortgages. They are using mortgages that offer a fixed rate for a period of time, but permits interest rate (and payment) changes in the future. The homeowner has no idea what the payment will be a few years down the road. The mortgage industry has a nice sounding name for these products: adjustable rate mortgages (ARMs). I don't even like the name of these loans. The term adjustable implies that just a slight tweaking may occur, such as adjusting your car seat for a more comfortable ride. It doesn't sound bad at all. In fact, an adjustable rate can wreak havoc on a homeowner's payment. Consider this example: Let's say a person takes out a $200,000 ARM at an introductory rate of 5 percent. The payments on the loan would be $1,074 a month. If rates rise to 8 percent three years from now, the payments would rise to $1,468 per month. That's an increase of more than 35 percent. For many families, that would cause much more than a slight adjustment in their finances. For some, it would wipe them out. The interest rates on ARMs are set by short-term interest rates. These are the rates that the Federal Reserve manipulates when it lowers or raises rates. After the terrorist attacks on 9/11, the Fed lowered rates to their lowest level in some 40 years. Interest rates on adjustable rate mortgages were at historical lows. Over the past year or so, the Fed has been increasing short-term rates at a rapid clip. Today, the interest rates on ARMs are not that different from fixed rate mortgages. In most cases, a person can lock in a fixed rate for 30 years for about 0.5 percent higher than an adjustable rate. With rates on ARMs not much less than fixed rate mortgages right now, why would anyone take out an ARM? Do most homeowners carefully consider the risks before opting for this type of loan? Or are they rolling the dice and hoping for the best? Obviously, no one can predict where interest rates are heading. It is possible that rates will never again rise. Possible, but not very likely. If history is any guide, it has shown that rates can rise to much higher levels than they are right now. Rates on ARMs were 7 percent just five years ago, which is about 1 percentage point higher than fixed rates are today. Isn't it quite possible that rates will be that high again in the next five years? I am not predicting a rise in rates. But I know this: Rates on fixed-rate mortgages are a bargain right now. They are cheap. The rates are not that much higher than ARMs. Best of all, a mortgage with a fixed rate carries with it a fixed payment. There are times when ARMs make sense, mainly for those who plan to move in a year or two or for those who have the cash flow to afford any payment. But for the typical American, an ARM is just too risky. As for the increasingly popular interest-only loans, most of these loans have a fixed payment for one to five years. After the initial period, the interest rate adjusts, as it does on traditional ARMs. However, there are some interest-only loans where the interest rate is fixed for the life of the loan. If you must use an interest-only loan, at least opt for one with a fixed interest rate. (Scott Hanson, CFP, is a senior adviser with Hanson McClain, an investment advisory company and registered principal with Securities America, member NASD/SIPC. E-mail questions to questions@moneymatters.com.)