Adjustable-rate mortgages may be a bargain for those planning a mortgage refinance.

Why an ARM Could Be Your Best Refinance

Fixed mortgage rates are all the rage these days, and it's no wonder. When interest rates ducked below 5% in the wake of the European/Grecian panic, fixed-rate mortgages reentered the spotlight.

But what's being lost in all the hoopla is that, for the lowest mortgage rates, you'll need to look at other loan products.

Adjustable-Rate Mortgage Rates Are Extra Low

A look at Freddie Mac's rate survey or HSH.com's mortgage rate graphs tells the story: the relative rates on adjustable-rate mortgages (ARMs) are the best they've been in years. What's a relative interest rate? It isn't what the bank owner's mom gets when she takes out a mortgage. It's the difference between the average interest rate for a 30-year fixed-rate mortgage and that of an ARM loan--and right now, it's very favorable to those who choose ARMs.

In January 2005, ARM rates were relatively low. The refinance mortgage rates for 5/1 ARMs were on average 0.67% lower than those for 30-year fixed-rate mortgages. But in May 2009, the difference was only 0.03%! There was virtually no advantage in assuming the risk of a 5/1 hybrid ARM.

In the spring of 2010, however, that difference expanded to just over 1%. That means if you can find a 30-year mortgage at 5%, you can probably find a 5/1 hybrid ARM at 4%, and perhaps a 3/1 hybrid ARM at 3.50%.

Hybrid ARMs: Fixed-Rate Safety Plus Low-Rate Savings

How does a hybrid ARM impart safety and low mortgage rates? It combines a low fixed mortgage rate for a specified period of time--protecting the borrower from inflation in the short term--with an adjustable phase, which protects the mortgage lender from inflation over the long haul.

With a hybrid ARM, mortgage lenders get more protection from inflation than they would by offering a fixed loan, and borrowers get more protection than they would from an ARM. The resulting interest rate is a compromise: lower than a fixed-rate home loan, higher than an adjustable-rate mortgage refinance.

Hybrid adjustable-rate mortgages can come with a variety of terms. Common ones are 10/1 ARMs, 7/1 ARMs, 5/1 ARMs, and 3/1 ARMs. The first number represents the number of years the initial rate is fixed, and the second number indicates how often the loan may adjust once the fixed period elapses. For example, some lenders offer a specialty 3/3 ARM, which means that the rate can adjust every three years after the first three years.

Refinancing with a Hybrid ARM vs. a 30-Year Fixed-Rate Mortgage

If you haven't entered into a lifelong commitment with your home, refinancing to a hybrid ARM could be very sensible. Say, for example, that you plan to keep your home another three to five years. If you can get a 30-year fixed-rate refinance at 5%, a 5/1 hybrid ARM at 4%, or a 3/1 hybrid ARM at 3.625%, how much can you save with the ARMs?

Assuming that your mortgage balance is $350,000, the principal and interest payments for each of these refinanced mortgages would be:

• 30-year fixed-rate mortgage at 5%: $1,879
• 5/1 hybrid ARM at 4%: $1,671 ($208 less than the 30-year payment)
• 3/1 hybrid ARM at 3.625%: $1,596 ($283 less than the 30-year payment)

In three years (36 payments), the savings from the 5/1 hybrid ARM over the 30-year fixed would be $7,488, and the savings from the 3/1 hybrid ARM over the 30-year fixed would be $10,188. Imagine investing that or paying off some high-interest debt with the savings. And if you aren't planning to keep your property beyond the initial fixed period, you aren't giving up anything to reap these benefits.

Shop Smart

Make a good deal a great deal by shopping intelligently for your ARM. Get Good Faith Estimates (GFEs) from every mortgage lender you're considering. Read your adjustable-rate mortgage riders, and don't commit to anything you don't understand. ARMs are about more than the lowest mortgage rate--you need to compare terms such as margins, indexes, rate caps, and floors. But the extra bit of work can be well worth it.