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Originally published Friday, May 20, 2011 at 5:00 PM

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Despite risks, adjustable-rate mortgages have their advocates

Fixed mortgage rates remain below 5 percent, and these days fewer and fewer homebuyers seem to be opting for adjustable-rate loans.

The Philadelphia Inquirer

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Fixed mortgage rates remain below 5 percent, and these days fewer and fewer homebuyers seem to be opting for adjustable-rate loans.

But low fixed rates aren't the only reason adjustables are financing just 7 percent of all home-purchase loans, according to figures from Freddie Mac.

"Homebuyers have shied away from ARMs because they are wary of the risks ... the potential for much larger payments if future interest rates are significantly higher," said Frank Nothaft, Freddie Mac chief economist.

In 2004, adjustables' share of all loans reached a high of 36 percent. Their low point came in early 2009, when just 2 percent were ARMs. Nothaft expects the share to rise to 9 percent this year.

Basically, an adjustable-rate mortgage is a loan with an interest rate that changes. ARMs may start out with lower monthly payments than fixed-rate mortgages, but the Federal Reserve advises borrowers to consider these points:

• Monthly payments on the loan can go up, maybe by a lot, even if interest rates do not increase. And payments may not go down much, or at all, even if interest rates drop.

• You can end up owing more money than you borrowed, even if you make all your payments on time.

• An early payoff in the hope of avoiding higher payments might incur a penalty.

If you plan to buy a house this year, should you consider an adjustable-rate mortgage?

Peter Buchsbaum, branch manager at Gateway Funding/Arlington Capital in Horsham, Pa., isn't a fan,, believing the risk isn't fiscally responsible.

"Five years ago, had I offered a client a cheaper rate for a five-year adjustable because he said he was moving in five years, that borrower would now be in harm's way," Buchsbaum said. "I learned a long time ago that my crystal ball has stopped working. I only know what now is."

Rates will always change, he said. "If my client asked me to lend them money on a shorter term because he or she felt it prudent, I would make sure there was a lifetime rate cap."

A lifetime cap is the maximum interest rate that may be charged at any point on an adjustable-rate mortgage. For example, if an ARM has an initial interest rate of 5 percent and a lifetime cap of 5 percent, the maximum rate that may be charged is 10 percent.

"Interest rates are so reasonable today, and the values are so much more reasonable than three years ago," Buchsbaum said. "Why not buy your home for a longer term and live in it like a home, rather than an investment vehicle?"

Holden Lewis, mortgage columnist, said there weren't many circumstances in which it was wise for a middle-class person to buy a house using an ARM.

"It makes sense for buyers who are certain that they will sell the house within a year or two of the end of the fixed-rate period," he said.

A young professional — a newly minted lawyer or doctor who expects income to skyrocket within a few years — might get an adjustable for a house that would be unaffordable with a fixed-rate loan but will be affordable once income rises, Lewis said.

"But under today's stricter lending guidelines, that borrower will have trouble qualifying for a loan. Maybe it's better to buy a starter home at the beginning, even for tomorrow's 'masters of the universe.' "

Harry Pecci, a loan officer with Prosperity Mortgage in Doylestown, Pa., said he is a big fan of ARMs. "Most people will refinance or move within six or seven years, and the saving in the meantime is significant."

Based on recent rates, a $200,000 mortgage with an adjustable rate will save the borrower $166 a month compared with a fixed-rate loan, Pecci said.

Federal Housing Administration ARMs have an advantage over conventional adjustable loans, Pecci said, because you qualify at the lower rate, for more purchasing power, and with lower rate caps.

Lewis said that though many lenders say adjustables are cheaper in the long run, "those monthly payments are short-run phenomena."

"With a fixed-rate loan," he said, "you know what your monthly payments will be years from now."

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