Which Adjustable Rate Mortgage Do You Choose?

March 25, 2002, Reviewed February 13, 2011

"I am trying to choose between different adjustable rate mortgages (ARMs) offered by a local lender: 3/1, 5/1, 7/1 and 10/1 at rates of 6%, 6.125%, 6.25% and 6.375%, respectively. I plan to stay in my house for at least 10 years. Which one is the best for me?"

The numbers you use to describe the ARMs refer to the period for which the initial rate holds, and the rate adjustment period after the initial rate period ends. On a 3/1, for example, the 6% rate holds for 3 years, after which the rate adjusts annually. All these ARMs have annual rate adjustments after the end of the initial rate period.

There is no "right" answer to your question. The decision involves a judgment about the likelihood of higher interest rates in the year ahead, and your ability and willingness to take that risk. Higher rates on ARMs with longer initial rate periods can be viewed as insurance premiums for longer protection. Rational people can have different views on how much insurance they want to buy. I will indicate how I would go about making the decision, but your answer might well be different.

The first thing you need to know is whether these ARMs differ in respect to features other than the initial rate and the initial rate period. All adjust the rate by adding a margin of 2.75% to the one-year Treasury index at the end of the initial rate period, and each year thereafter. In addition, on all of these ARMs, the maximum rate over the lifetime of the mortgage is 6% above the initial rate. Since these features are the same, they do not enter the decision process.

However, there is a difference in the rate adjustment cap applicable to the first adjustment. The first rate adjustment can involve an increase of no more than 2% on the 3/1 and 5/1, and no more than 5% on the 7/1 and 10/1. This is an important difference.

I approach this by first comparing the 3/1 with the 5/1. The question is whether 2 years of protection is worth a rate difference of .125%? To me it is. If you took the 3/1 and banked the difference in payment, the savings would only cover a rate increase to 6.35% at the end of 3 years. Any increase larger than that makes the 3/1a loser relative to the 5/1. I opt for the 5/1.

I then compare the 7/1 with the 10/1. If it is worth paying an additional .125% in rate for 2 years of protection, then it is worth paying the same amount for 3 years of protection. I opt for the 10/1.

Finally, I compare the 5/1 and the 10/1. Here, the question is whether .25% difference in rate is worth 5 years of protection. In this case, however, the larger adjustment cap on the 10/1 reduces the protection. The largest possible increase in the rate on the 5/1 is 2% whereas the rate on the 10/1 could increase by as much as 5%. For this reason, I opt for the 5/1.

But these decisions are all quite close. The reason you are having trouble making a decision is that the varying amounts of risk in these ARMs has been carefully priced by the lender. The ARMs are priced so that the lender is indifferent which one you select, and it is not surprising that many borrowers might be equally indifferent.

If the different ARMs were offered by different lenders, you could find larger price differences that could lead to easier decisions. On the other hand, comparing ARMs offered by different lenders is complicated by the fact that the ARMs may have different indexes, margins or lifetime rate maximums.

Want to shop for a mortgage on a level playing field?

Why Shop for a Mortgage with the Professor?

  1. Receive His Help in Finding the Type of Mortgage That Best Meets Your Needs
  2. Shop Prices Posted Directly by His Certified Lenders
  3. Shop Prices Fully Adjusted to Your Deal
  4. Shop Prices That Are Always Current
  5. Get Him as Your Ombudsman Just in Case

Read More About the Support and Protections Listed Above

Sign up with your email address to receive new article notifications