SANTA CRUZ (February 10, 2008) - Adjustable rate mortgages take the future risk out of the lender’s hands and places the risk of rising rates squarely in the hands of the borrower. In return, lenders offer lower rates for ARMs (adjustable rate mortgages) and higher rates for fixed rate mortgages.

ARMs are appealing for a number of reasons. At one end of the spectrum, borrowers who are on tight budgets enjoy lower payments with an ARM; on the other hand, high income borrowers will often choose to go with a small down payment and an ARM in order to maximize their monthly cash flow so that they can set aside money for other investment vehicles (stocks, bonds, real estate, etc.).

As an example, the monthly payments required for a mortgage of $600,000 at a 30 year fixed rate of 6.25 percent would be $3694. If an ARM was chosen that had a fixed rate of 5.5 percent for the first five years (followed by 25 years of adjusting rates), the monthly payments would be set at $3407, representing a savings of $287 per month, for the first five years.

The downsides of an ARM can be significant. To avoid an increase in interest rate and payments after the fixed rate period is over a borrower with an ARM will most likely have to refinance. Refinancing is not only expensive but it also is dependent upon the borrower’s income and credit and, even more importantly, may not be possible at all if the home’s value slides. This is what is now happening across the country: countless borrowers are not able to refinance out of their ARMs because their home’s value has fallen so much that there is little or no equity left.

ARMs come in many shapes and sizes. Some have a fixed rate for the first 3, 5 or 7 years and then go adjustable and some adjust every month. The ones that adjust every month traditionally have the lowest rates. For example, there is one jumbo monthly ARM (for loan amounts up to $2,000,000) that has a rate of 4 percent this month. This ARM requires the borrower to make a payment of at least the interest portion each month. In the above $600,000 example and at the rate of 4 percent, this loan would require a payment of just $2,000. Compare that to the 30 year fixed rate payment of $3694.

There is an innovative loan program that has been available for just a year or so in the U.S. but has been popular in other countries for many years. It combines your mortgage and an equity line of credit with your checking account. Every time you make a deposit into your checking account, your mortgage balance goes down; consequently, you pay much less mortgage interest over the life of your loan. This loan has the ability to shorten the life of a 30 year mortgage by 10 or more years without altering your payments. I wrote about this unique loan product in this column last July.

For those on a tight budget who would rather not have to worry about what rates (or home values) are going to do tomorrow, the 30 year fixed rate mortgage provides the maximum security and for this reason is the most popular loan product across the country. With rates on this mortgage between 5.5 and 5.75 percent for loan amounts at or under $417,000 and rates just above 6 percent for larger loans, it is a great time for refinancing homeowners and homebuyers to take advantage of the current economic situation.

There are obviously many factors to consider when deciding what to do about your mortgage. The loan that is best for you depends on many factors that are best discussed with your accountant, financial planner and mortgage professional. Make the effort to find out what your options are while rates are low.

This column is written every Sunday by Peter Boutell, Certified Mortgage Planner and a principal at Santa Cruz Home Finance. You may reach him at (831) 425-1250 or email him at Peter@SantaCruzHomeFinance.com.