You’re in the market for a new home. As you meet with your lender to discuss mortgage options, they present you with a choice: Go with a fixed-rate mortgage to lock in a set interest rate for the life of your loan, or take out an adjustable-rate mortgage (ARM) with a fluctuating rate that could start lower but rise over time. Which do you choose?
While fixed-rate mortgages offer stability, adjustable-rate mortgages have unique advantages that attract borrowers – especially those looking for short-term financing. Here’s a look at why ARM loans can be an appealing choice and what borrowers should consider before taking the plunge.
Lower Rates To Start
One of the biggest draws of adjustable-rate mortgages is that they often come with tempting introductory rates. Known as “teaser” or “introductory” rates, these starting percentages are lower than the rates offered for fixed mortgages.
For example, you might be able to get a 5-year ARM with a starting rate of 3%, compared to a 30-year fixed mortgage with a 5% rate. That 2% difference means lower monthly payments at the outset – several hundred dollars less per month, potentially. This allows borrowers to afford a larger loan amount than they could with a fixed mortgage.
It’s not just about size, either. The cost savings from a lower teaser rate can free up your monthly budget for other goals like travel, home upgrades, or aggressively paying down principal.
However, it’s key to note that with an ARM, the party won’t last forever. Once the intro period ends, the rate adjusts based on market conditions. More on that risk later.
Payment Flexibility To Fit Your Situation
Beyond tempting teaser rates, adjustable-rate mortgages offer enticing payment flexibility that appeals to many borrowers.
Certain types of ARMs, like payment-option ARMs, let you choose from multiple payment amounts each month. For instance, you may have the choice of an interest-only payment, a minimum payment, a 15-year payment, or a 30-year payment.
This ability to tweak your payment amount can come in handy if your income fluctuates. Having options allows you to reduce your payment if money gets tight in a given month.
ARMs with negative amortization also provide payment flexibility, albeit with a catch. These loans let you pay less than needed to cover the interest due, increasing your balance over time.
While flexibility sounds nice, it’s wise to understand the risks before opting for an ARM with payment options or negative amortization. But for borrowers with variable incomes, the ability to scale payments up or down can be a major perk.
Refinancing Anytime Rates Drop
Here’s another useful feature of ARMs for borrowers – the ability to refinance and take advantage of rate declines without waiting out a long fixed term.
With a fixed-rate loan, you’re stuck with the same rate for the full duration, often 30 years. But adjustable-rate mortgages allow you to refinance whenever rates go down to secure a better deal. You don’t have to sit around hoping rates fall at the end of your multi-year fixed term.
This refinancing flexibility means you can maximize savings over the life of your mortgage by capitalizing on dips in interest rates. Savvy ARM borrowers keep an eye on market forecasts and trends so they can act when the timing is right.
Lower Lifetime Costs Possible
Under the right conditions, adjustable-rate mortgages can cost less than fixed-rate mortgages over the full term.
If interest rates trend downwards during the life of your ARM, your mortgage costs will decrease along with them (after the teaser period). In effect, you’re betting on rates declining and protecting yourself against rises with caps (more on that later).
Run the numbers for both fixed and adjustable loans to see if an ARM could save you money long-term based on rate projections. It likely comes down to your outlook on where rates are headed.
One analysis found borrowers who took out ARMs between 2000-2010 ended up paying $53,000 less than fixed-rate borrowers over those 10 years as average rates fell from 8% to 4%. Of course, your individual savings would vary based on your loan terms. But the potential is there.
Short-Term Financing Needs
Here’s when adjustable-rate mortgages really shine – if you only plan on keeping the home and loan for a few years.
The lower introductory rates make ARMs ideal for properties you intend to sell soon, whether you’re purchasing a starter home, flipping a home, or relocating for a short-term job assignment. You can take advantage of lower payments for a few years before the rate adjusts upwards.
Even if rates rise down the road, you likely won’t feel the brunt of it since you’ll be selling and paying off the loan before higher rates kick in. You get the savings upfront when you need it most.
Generally, experts suggest ARMs make sense for time horizons of 5 years or less. The shorter your holding period, the more worthwhile an ARM becomes.
Key Features and Terms of ARM Loans
Now that we’ve covered the main attractions of adjustable-rate mortgages for borrowers, let’s look at some key features and terms to understand. This gets a bit technical, but grasping these concepts will help you assess risks and make an informed decision.
Index rate – This is a benchmark interest rate index like the Prime Rate, LIBOR, or 10-year Treasury yield. The ARM’s interest rate will adjust based on movements in the index rate.
Margin – The margin is an extra percentage the lender adds to the index rate to determine your overall interest rate. A lower margin means more savings when index rates fall. Margins are generally fixed over the life of the ARM.
Interest rate caps – These limit how much your rate can fluctuate. A yearly cap limits increases at each adjustment period while a lifetime cap sets the max rate for the loan’s duration. Know the caps before committing.
Hybrid ARM – This is an adjustable-rate mortgage with a fixed intro rate for a set number of years before it starts adjusting annually based on the index plus margin. A 5/1 ARM has a 5-year fixed period and then a 1-year adjustment period.
Negative amortization – When your payment doesn’t cover the interest accrued, the unpaid amount gets added to your principal balance. This increases your loan amount and interest costs over time. Risky!
Recasting – This recalculates your payment amount to get your loan to fully amortize by the end date based on accrued principal and current interest rate. Done automatically on some ARMs at set intervals.
Getting familiar with these key ARM terms will help you make an informed decision and understand the trade-offs.
What Are the Advantages of Adjustable Rate Mortgages Compared to Traditional Mortgages?
Adjustable rate mortgages offer the advantage of lower initial interest rates, making them a good option for those who plan to relocate or refinance within a few years. This flexibility in rates is one reason why select we get homes with adjustable rate mortgages, compared to traditional fixed-rate mortgages.
The Risks and Considerations of Adjustable Rate Mortgages
Adjustable-rate mortgages can be complex products with real risks. Here are some key points to keep in mind:
- Your interest rate and monthly payments can rise significantly. After the intro period, your rate fluctuates based on market conditions – and rates may climb higher than your fixed rate alternative. Budget for potentially substantial payment increases.
- Caps provide some protection but don’t prevent increases. Typical ARMs limit annual increases to 2% and lifetime increases to 5-6%. But your rate can still rise to the cap over time, raising costs.
- Negative amortization increases your loan balance and interest costs. Only make minimum payments if you’re certain you can handle the higher eventual recalculated payment to pay down accrued interest.
- Ensure you can afford higher future payments. Consider a worst-case scenario – your rate rising to the lifetime cap quickly. Make sure your finances could withstand maximum potential increases.
- ARMs are complex with unfamiliar terms. Learn about indexes, margins, caps, negative amortization, and other concepts before getting an ARM. Don’t take the lender’s word at face value – do your own research.
The bottom line is adjustable-rate mortgages come with inherent risks. Make sure you grasp the potential downsides before moving forward.
Should You Consider an Adjustable-Rate Mortgage?
Adjustable-rate mortgages offer tempting benefits like lower initial rates, flexible payments, and the ability to refinance freely. But they come with the risk of rising rates.
Here are some good candidates for ARM loans:
- Homeowners who plan to move within 5 years or less. You can take advantage of low introductory rates without worrying as much about future increases.
- Borrowers who expect to see their incomes rise substantially. Higher future earnings can help you handle potential payment increases down the road.
- Those with large down payments or equity positions. More equity gives you flexibility if you needed to sell or refinance as rates rise.
- Financially savvy borrowers who understand the risks. Adjustable-rate mortgages reward active monitoring and refinancing at optimal times as rates shift.
- Anyone looking for lower costs in the short-term. You’ll benefit from the introductory rates and can refinance later if rates trend up for the long haul.
adjustable-rate mortgages can be a smart choice or dangerous pitfall depending on your situation. If you’re disciplined and plan to own the home short-term, they can provide real savings and flexibility. But if you want long-term stability, a fixed-rate mortgage may be the way to go. Analyze both options carefully before deciding which type of loan works best for your needs.