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The Current Case for an ARM

If you are planning to buy a home, how should you finance it? The question is simple, but the answer may not be what first comes to mind.

"People like to go right to the 30-year, but that's the wrong thing to do," says Richard Rosso, a partner at Clarity Financial in Houston, referring to the 30-year fixed-rate mortgage, which was the traditional way people could borrow to buy a home up until the early 1980s.

It's hard for some to believe, but the adjustable-rate mortgage as a widely available way to borrow is only a few decades old. Maybe for that reason, the idea that the fixed-rate mortgage as the go-to product seems to have stuck in the American psyche like chewing gum on the sole of a shoe.

[See: 10 Tips for Couple and Young Families to Build Wealth.]

There are other choices that may be better for your finances.

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How long will you live there? "Match the mortgage to what your anticipated stay in the home is going to be," Rosso says.

For most people, the average time they own a home is about seven years, he says. That means that a mortgage with a borrowing cost that is fixed for seven years, and adjustable annually thereafter, makes more sense than one that is the same for 30 years.

Here's why: The interest rates on loans that are adjustable tend to be lower than those on mortgages that keep the same borrowing cost for the life of the loan.

For instance, the rate for a 30-year fixed-rate mortgage averaged 3.52 percent the week of July 7, according to Bankrate.com. That compares to 2.95 percent for an adjustable-rate mortgage that is fixed for the first five years during the same week.

In this case, if you were going to stay in the property for five years you'd get the benefit of more than half a percentage point of lower borrowing costs each year for five consecutive years. Simply calculated, that could mean savings of thousands of dollars over the period depending on how much money you borrowed.

Rate anxiety. "I'm not an advocate of the one-year adjustable rate-mortgage," Rosso says, which is a loan that resets its borrowing cost every 12 months. "If you can pay more of the loan principal off faster, then it can make financial sense."

But, he says, there is a certain emotional anxiety when people wonder whether the rate will jump after a year.

The goal of limiting interest-rate anxiety is what has some advisors still recommending the 30-year mortgage in certain circumstances.

[See: Artificial Intelligence Stocks: 10 Companies Betting on AI.]

"Living somewhere for the long-haul would benefit from a fixed rate," says Rose Swanger, a financial planner at Advise Finance, in Knoxville, Tennessee.

If you are staying put for the duration, then the higher cost of the fixed-rate loan may help ease worries about changes to your monthly budget due to changes in borrowing costs.

How lumpy is your income? Not everyone receives their annual income spread evenly throughout the year. For some, it comes in big chunks usually preceded by a trickle, at least on a relative basis.

"Our Wall Street clients prefer ARMs since they receive the majority of their annual compensation as bonuses," says James Parks, president of Parks Wealth Management in Ridgewood, New Jersey.

Although things have changed a bit in the way investment bankers are paid, it is still the common practice for financial institutions to pay the big rewards once per year. It can sometimes mean people receive a bonus which is multiple times the size of their base salary.

Therefore, it can make sense for such bankers to find a way to keep their monthly payments low throughout the year by borrowing with an ARM, but then use the bonus check to pay down the principal, Parks says.

The outlook for interest rates: lower for longer. "When rates decline the ARM rate may decline without the added costs and hassles of refinancing a fixed-rate mortgage," Parks says.

Indeed, there are reasons to believe that given the current economic outlook in the U.S., and the rest of the world, rates will at least stay low or perhaps even drop.

"We are now in a period where what is controlling interest rates is not demand for capital but supply of capital," says Brad McMillan, chief investment officer for Commonwealth Financial Network.

In more simple terms, there is a lot of money in the global banking system competing for borrowers. That supply of money for potential loans will keep rates low until the excess supply of cash is absorbed.

[Read: 7 Great Stocks That Cost $10 or Less.]

Also, the stress in Europe caused by Britain's decision to leave the European Union (the Brexit) is pushing down borrowing costs worldwide. That will give the Federal Reserve some pause about raising the costs of borrowing dollars too aggressively while other central banks are lowering interest rates.



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