The 5/1 ARM stages comeback for buyers, refinancing owners

A year ago, 30-year fixed-rate financing was the name of the game. Recently, the adjustable-rate mortgage made a comeback.

The 5/1 ARM is popular with some homebuyers and homeowners with equity who are refinancing. The attraction of a 5/1 ARM is that it offers a fixed rate for five years that is significantly lower than what is available on 30-year fixed-rate mortgages.

At the end of May, 5/1 ARMs were available from some lenders with interest rates as low as 3.75 percent with no points. Points refer to the loan origination fee: 1 point is equal to 1 percent of the mortgage amount. The interest rate on a 30-year fixed-rate loan was as low as 4.5 percent with 1 point. Interest rates vary from one location to the next, and not all mortgage products are available in every state.

Last year, high-end buyers paid a premium for jumbo financing, if they could find it at all. At the end of May, some lenders offered 5/1 ARMs for 4.5 percent in amounts up to $1 million to borrowers with a 20 percent cash downpayment, and up to $2 million or more with 25 percent down.

The downside of a 5/1 ARM is that at the end of the fifth year, your mortgage payments could jump significantly. To determine your new interest rate when the five years of fixed-rate financing expires, a margin is added to an index that fluctuates over time to arrive at your ARM rate for the next year. There should be a cap on how high the rate can go each time it adjusts (in this case, annually) after the initial five-year period.

Let's say the index on your 5/1 ARM is the 1-year constant-maturity Treasury rate (CMT). In April, the CMT was 0.45 percent. If your margin is 2.75 percent, and your mortgage converted to an ARM in April 2010, your new interest rate would have been 3.2 percent. However, in April 2006, the CMT was 5.9 percent, which would have given you an interest rate of 8.65 percent and a huge jump in your mortgage payments.

HOUSE HUNTING TIP: Often the initial fixed-rate payments on a 5/1 ARM are interest only. Some 5/1 ARMs start at a rate -- called a teaser rate -- that is lower than the current index plus the margin. This could result in a significant rate and monthly payment increase at the first adjustment. Make sure your 5/1 ARM doesn't have a prepayment penalty, so that you have the flexibility to pay down the principal balance at any time without penalty.

One way to protect against a large increase in your mortgage payment when the loan converts from fixed-rate to adjustable is to pay down the principal balance. Each time the interest rate changes, an ARM is recast so that the monthly payments are based on the new principal balance.

Despite the savings possible in the first five years of a 5/1 ARM, low fixed-rate mortgages are the choice of most homebuyers and borrowers who plan to stay put for the long term. In the current volatile housing market, buying for the long haul is a good strategy.

Homeowners who don't intend to stay long in their home are good candidates for a refinance to a 5/1 ARM. For example, empty-nesters who plan to trade down to a smaller home within the next five years would pay the loan off before it converted to an ARM, with possibly much higher monthly payments.

It's even possible to get cash back on a 5/1 ARM refinance, or consolidate debt, as long as you have sufficient equity in your home.

THE CLOSING: On a refinance, some lenders will lend up to 80 percent of the appraised value, less loans you already have secured against the property.

Dian Hymer, a real estate broker with more than 30 years' experience, is a nationally syndicated real estate columnist and author of "House Hunting: The Take-Along Workbook for Home Buyers" and "Starting Out, The Complete Home Buyer's Guide."