Lost in the euphoria over record low rates for 30- and 15-year fixed-rate mortgages is perhaps an even better alternative: adjustable mortgages.
Adjustable-rate mortgages get a bad rap, lumped as they often are in the "toxic" category with such infamous products as interest-only loans, negative amortization and no income, no asset mortgages.
But today's most popular ARMs -- called "hybrid" ARMs because they carry fixed rates for the first five or seven years, after which their rates begin adjusting annually -- are excellent deals for the proverbial "right" borrower.
That would be someone who knows he is going to move on -- either buy another house or refinance the current one -- before the fixed-rate portion of the ARM runs out. But as we'll see in a moment, the time frame until you are in the red with a hybrid ARM is actually somewhat longer.
According to mortgage intermediary Freddie Mac, the average for 30-year, fixed-rate mortgages in early June was a record low 3.75 percent. The following week, the average fell even more, to 3.67 percent. The rate for a typical 15-year loan was an astounding 2.9 percent. The 5/1 ARM was a tad cheaper at 2.8 percent.
But forget those rates. While they grabbed all the headlines, they aren't terribly realistic, because they are an average of what the "ideal" borrower would have to pay. And as everyone knows, ideal borrowers are few and far between.
So here's an analysis based on rates that lenders were actually quoting in early June on LendingTree, the online service where lenders bid for your business. It's based on an average of the offers quoted by lenders on $225,000 mortgages to borrowers with a 20 percent down payment and a FICO score of 720:
On a 30-year fixed loan, the typical LendingTree rate was 3.91 percent, resulting in a monthly principal and interest payment of $1,063. The 5/1 ARM was pegged at 2.75 percent, with a payment of $919.
As a result, the ARM borrower would pay $144 less each month for the first five years of the loan, for a total savings of $8,640.
So far, so good. But what happens when the adjustment period kicks in?
In the worst possible case, you wouldn't start losing money with the ARM in this example for more than seven years -- 91.4 months, to be exact. The reason: Adjustables come with protective annual and life-of-the-loan interest rate caps that typically limit adjustments to no more than 2 percentage points annually and no more than 6 points over the duration of the loan.
Consequently, in our example, under the worst of circumstances, the adjustable rate in year six would jump to 4.75 percent, while the fixed-rate would remain at 3.91 percent.
That means the payment from month 61 through month 72 would be $72 higher for the ARM -- $1,135 vs. $1,063. Over the 12-month period, you pay out $864 more for the ARM. But you'd still be ahead $7,776 because of the $8,640 you didn't have to pay in years one through five.
In year seven, the ARM rate might jump again, to as high as 6.75 percent, in which case your payment would rise to $1,368. In such a worst-case scenario, that's $305 more a month than the payment on the fixed loan.
But again, while you pay more, you're still ahead. Indeed, by the end of the loan's seventh year, your total payments with the ARM are $4,974 less than they would have been with the fixed loan.
Even if rates jump two more points in year eight, hitting 8.75 percent and the 6-point maximum, you wouldn't be a loser with this loan until the 91st month. At that point your payment will be $1,614, or $551 a month more than the payment on the fixed loan, and you've lost everything you saved.
Is this loan for you? If you are certain you are going to move within the first five years, absolutely. This kind of savings just can't be ignored, and there is no risk whatsoever. If you can afford the annual hits, you still have more than seven years to move or refinance before you lose money by not taking the fixed-rate loan.
So the ARM should rate at least a second look. Even with fixed rates at record low levels, says LendingTree's Doug Lebda, ARMs can be a "valuable risk-adjusted alternative."
A few more points to consider:
-- Only you know how long you are going to stay put. But according to the Census Bureau, Americans move or refinance every six or seven years on average. Are you the typical itinerant homeowner, or is this house where you plan to raise your kids and live until Middle Youth sets in?
-- Rates go down as well as up. That means there's always the possibility that once your rate tops out at the 6-point cap, it could drop again. The rate could recede even before it hits the maximum. Or it may never, ever go down.
Betting on interest rate movements is always a crapshoot. But with rates today as low as they are, the safe gamble is that they will rise from here. How high and for how long is anyone's guess. So if you have a low tolerance for this sort of thing, your timeline with a five-year ARM is exactly that, five years.
-- You'll receive a smaller tax break on the ARM because you'll pay less interest, at least initially. But mortgage interest is a costly out-of-pocket expense.
Moreover, the tax deduction is not a dollar-for-dollar writeoff. Rather, it is based on your tax bracket. So, if you are in the 18 percent bracket, you'll be able to claim only 18 cents for every dollar you spend in mortgage interest.