ARM or fixed-rate? The difference is risk



Q: I am buying a new home within the next few weeks with a mortgage of $100,000. I can't decide between a 1-year ARM [adjustable-rate mortgage] or fixed-rate mortgage. Can you help Marlene Roberson

Owings Mills

A: The major questions are: How long do you plan to live in the home? And are you willing to risk rates going up?

The interest rate on the ARM -- though cheaper initially -- has a risk of rising, unlike the fixed-rate loan.

Most conventional ARMs have a lifetime cap of 6 percent and 2 percent a year -- that is, the interest rate on an ARM can rise 2 percent a year and 6 percent over the life of the loan.

The interest rate on an ARM -- after the introductory rate expires, usually after a year -- is based on an index rate, such as the one-year Treasury bill rate, plus a margin, normally 2.75 percent. With a one-year Treasury rate of 4.875 percent, the ARM would be 7.625 percent. In contrast, a 30-year fixed-rate loan today is about 8.50 percent.

If the ARM increased by 2 percent -- the maximum -- each year, in about 4 years you will have paid the same amount of principal and interest on both types of loans.

At the end of seven years the ARM, if it is at the maximum rate, would cost you about $5,700 more in interest than the fixed rate. Your decision should be based on how much risk you are willing to take and how long you expect to live in the home.

Explore other ARM products -- like a 5/1 or 7/1 ARM if you plan to live in this home more than 6 years. (These loans have fixed rates for five or seven years -- usually below 30-year fixed rates -- and then convert to an ARM.)

You may not save as much money in the first years as with the 1-year ARM, but you have less risk in the fourth or fifth years.

A fixed-rate loan gives you the same principal and interest payment during the entire time you live in the home. And an ARM offers a lower rate in the beginning years but possibly higher principal and interest payments in later years.

The question is: Are you willing to take the risk?

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