BEND, Ore. (CNN/Money) – The interest rate on 30-year fixed-rate mortgages is still a bargain by historical standards, averaging just over 6 percent as of last week, according to Freddie Mac.
Yet, the percentage of buyers turning to adjustable rate mortgages (ARMs) has more than doubled over the course of this year.
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During the last week of November, nearly 27 percent of all mortgage applications were for ARMs, according to the Mortgage Bankers Association of America, verses only 11.9 percent during the first week in January.
Unlike fixed-rate mortgages, which lock in a rate for the entire life of the loan, ARMs guarantee a certain interest rate for a shorter period of time, ranging from one month to 10 years.
A five-year ARM, for example, gives you a fixed rate for the first five years of the loan. But then it becomes a variable rate, adjusting annually in most cases for the next 25 years of the loan.
In exchange for the risk that rates will go up in the long run, borrowers get a lower interest rate with ARMs than they would with a 30-year fixed-rate mortgage. At least for the short term.
Borrowers typically pay about one percentage point less for interest on a five-year ARM than they do for a 30-year fixed loan, according to Anthony Hsieh, CEO of HomeLoanCenter.com. Rates for three-year ARMs are even lower, while rates for seven- and 10-year ARMs are slightly higher.
"Anytime the 30-year fixed rate goes over 6 percent, consumers start asking for an alternative product," said Hsieh, noting that his company has seen a 20 percent increase in ARMs just in the past two weeks.
But rising interest rates are only part of the story.
Keith Gumbinger, vice president for HSH Associates, says that double-digit increases in home prices have also made ARMs more attractive. Rather than adjust their expectations to account for higher prices, some buyers turn to ARMs to keep their monthly payments within their budget.
At the same time, lenders have begun marketing ARMs more aggressively than they did in the past, added Gumbinger.
Perhaps most importantly, many buyers have realized that there's no good reason to pay more for a 30-year guarantee when you don't think you'll be in the same house for more than 10 years.
"People are a little more realistic about their time frame, especially young folks," said Gumbinger.
And indeed, ARMs seem to be most popular among younger buyers. "I can tell you that the older generation is more programmed to go with a 30-year fixed, in part because they remember how high rates were in the 1970s," said Hsieh.
"The younger buyers don't have those fears," he added. "Whether they're right or wrong we don't know, but in the immediate term everyone agrees that interest rates will be fairly tame."
Shortsighted or savvy?
To understand the appeal and the danger of an ARM, consider this scenario, which assumes that the 30-year fixed rate is 6 percent, while the rate on a five-year ARM is 5 percent.
For a $250,000 loan, the monthly payment with the ARM would be about $1,340, or about $150 less. But, if after five years interest rates rise to 8 percent – which economists say is not unreasonable to assume – the monthly payment for this loan could jump to $1,676.
"Looking back 10, 20 years ago when interest rates were high, taking an ARM was a pretty good gamble because rates were more likely to go down than up," said Greg McBride, senior financial analyst for Bankrate.com. "We're in the exact opposite environment now, and the likelihood is that will go up, not down."
But for many buyers, particularly first-time buyers, an ARM may in fact be the best choice. After all, what difference does a higher rate make if you plan to move anyway?
"The average homebuyer moves every seven to 10 years," added McBride. Depending on your timetable, an ARM is, for all practical purposes, a fixed-rate loan.
"It's a much better deal for someone who thinks they'll be in their house for, say, only eight years," said McBride.
Chances are you can't answer with absolute certainty how long you plan to stay in your house, but most homebuyers have a pretty good idea whether their current address is a starter home or their dream home.
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