As mortgage rates rise, ARMs finding favor

• Fixed-rate mortgages have climbed faster than adjustable-rate mortgages since May
• Payments are lower%2C but risk of increase later is higher
• Mortgage Bankers say 6%25 of mortgage applicants choosing ARMS%2C up from 4%25 in May

Karen Zoeller wasn't too worried about rising mortgage rates when she went house-hunting. But the 25% down payment requirement for an investment property took her aback.

So she pulled a old trick out of her bag: an adjustable rate mortgage. An ARM required just 20% down, with a 4.25% interest rate, about three-quarters of a point less than fixed mortgages being offered to investment buyers, she said.

"I don't intend to hold the property for longer than five years,'' said Zoeller, an intensive-care nurse from Arlington, Mass., who closed on the house Tuesday. "I can use the extra 5% to put windows in.''

ARMs aren't quite back with a vengeance — they're more creeping in from the shadows. Vilified for causing defaults once "teaser" rates spiked higher after 2006, ARMs fell into disuse while fixed mortgage rates plunged. But since May the share of ARMs among all mortgages has climbed by half, thanks to a little-watched gap in how rates are rising.

As the Federal Reserve mulls slowing its monthly bond purchases, rates for 10-year U.S. treasuries have climbed more than a percentage point between early May and July. Fixed-rate mortgages, which follow 10-year Treasuries, rose to 4.51% last month from 3.34% in January.

But ARMs follow short-term rates like one-year Treasuries. Because the Fed will keep short-term rates very low until unemployment is 6.5% or lower, one-year Treasuries traded at a 0.1% yield on Wednesday, down 0.04% in the last month.

The upshot: Fixed mortgage rates have risen twice as fast as five-year ARMs since speculation about the Fed's exit began, according to Freddie Mac data. So last week, 6% of mortgage applications were for ARMs, up from 4% in early May, according to the Mortgage Bankers Association of America.

The availability of ARMs keeps homes affordable, argued Barb Jandric, president of Edina Realty outside Minneapolis. It's one reason Edina didn't see buyer interest fall as rates began rising, she said.

The more expensive the house, the likelier it will have an ARM: 14% of the dollar value of new mortgage requests last week were for ARMs, said Matt Robinson, spokesman for the Mortgage Bankers Association of America.

"It can mean a difference of 1.75 (percentage points) in the interest rate,'' said Brian Koss, executive vice president of Mortgage Network, who said 5% to 10% of his most recent customers have switched to ARMs.

ARMs aren't for everyone. Their interest rates can rise after one, five, seven or 10 years, and the first jump can be a budget-busting 2 to 5 percentage points. They're best-suited for buyers who will move on or refinance before the rate changes, Koss said.

Even so, some lenders still advise against ARMs, arguing that fixed rates are still near multidecade lows.

"You can't lose sight of how amazing rates are,'' said Matt Weaver, senior lender at WCS Lending in Boca Raton, Fla. "It doesn't warrant the risk.''