Adjustable-rate mortgages may still make sense

Borrowers generally hate adjustable-rate mortgages, or ARMs, but this sentiment may be illogical, since ARMs often offer relatively low rates.

After all, why would average homeowners choose a high fixed-interest rate for 30 years when they stay put for only seven years?

Now, rates on bigger mortgages are giving borrowers cause to carefully consider ARMs, and mortgage specialists say they are worth a look.

"Some borrowers right now must consider an ARM," said Keith Gumbinger, a vice president at HSH Associates, a financial-industry publisher.

That is especially true, he said, of those who need so-called jumbo loans — mortgages so big that lenders cannot sell the loan to Fannie Mae or Freddie Mac, the government-sponsored companies that resell mortgages to investors.

Such loans carry more risk, so lenders charge interest rates of at least one-half of a percentage point more than for smaller loans.

The threshold figure for what constitutes a jumbo loan varies by region. That figure now is $567,500 for King and Snohomish counties. That may change Jan. 1, when Fannie Mae adopts a new number based on current home prices.

Lately, Gumbinger said, interest rates on 30-year fixed jumbo loans have hovered around 7.5 percent. At that level, a borrower with a $750,000 loan would pay $5,249 monthly.

By comparison, a buyer who opts for a 5/1 ARM — in which the rate remains fixed for five years but then varies every 12 months according to a particular market index — could get an initial interest rate of 6.56 percent. On a monthly basis for the first five years, the ARM costs $4,770, or $479 less.

The merits of that loan depend on a borrower's long-term plans. If the borrower plans to remain in the home for only seven years, there is little risk of financial calamity, since rates on many 5/1 ARMs can increase by only one percentage point annually. In the worst case, then, the rate would jump to about 8.5 percent.

If, however, the borrower keeps the home for many years and rates steadily rise, the borrower could end up paying the maximum rate, which is typically capped at six percentage points above the starting rate. A rate of 12.5 percent would certainly sting.

Of course, ARM rates can also drop, and borrowers can save if rates go down.

Interest rates on ARMs are commonly tied to one of three market indexes: the Federal Home Loan Bank's 11th District cost of funds index (COFI), the London interbank offered rate (Libor) or the one-year United States Treasury index (Treasurys for short).

The COFI is typically less volatile than the other indexes, Gumbinger said.

ARMs tied to the Libor have been hammered recently.

The timing of a loan's origination is also important: Borrowers whose Libor loans adjusted in August would enjoy a year of payments far below those whose loans adjusted Oct. 1.

In general, borrowers with the stomach for risk are better candidates for an ARM tied to the Libor or the Treasury index, Gumbinger said, while those seeking less volatility should opt for an ARM tied to the COFI index.

Seattle Times business reporter Elizabeth Rhodes contributed

to this report.