An adjustable rate mortgage (ARM) can be a smart choice for a borrower who plans to move, refinance, or pay off their mortgage in a few years time, thanks to the lower introductory interest rates and lower monthly mortgage payments.
On the other hand, adjustable rate mortgages are more complex than fixed-rate mortgages, with periodic mortgage rate adjustments that involve less certainty and more financial risk than other types of home loans.
Still, there’s no right or wrong answer for whether adjustable rate mortgages are a “good” or “bad” type of loan. It all depends on your specific circumstances. In order to decide whether an ARM is right for you, consider all the benefits and the drawbacks.
The Benefits of Adjustable Rate Mortgages
1. Lower Initial Interest Rates and Payments
ARMs feature a lower introductory interest rate than many fixed-rate loans, and a lower interest rate means a lower monthly mortgage payment. The fixed-rate phase of many hybrid ARMs, like 7/1 ARMs, can mean a lower rate and payment for the first 7 years.
2. Opportunity to Invest Your Savings
A lower monthly mortgage payment means more money in your pocket, which could be put to good use. Many ARM borrowers take advantage of the money they’re saving, which could be $100 or more per month, by investing in a higher-yield investment.
3. Greater Life Flexibility
Some homeowners settle in for decades after a home purchase, but others may need greater life flexibility, due to career or family commitments. An ARM can be a good idea for a buyer who might be on the move again soon.
4. Cheaper Alternative if You Plan to Move Again
Besides added flexibility, an ARM could be a cheaper alternative than renting or buying with a fixed-rate mortgage for homebuyers who plan to move again before a hybrid ARM’s fixed-rate period ends. An ARM could help you save money, whether you plan to relocate in a few years or move up from a starter home.
5. Protection with Rate and Payment Caps
Many ARMs now include caps that limit how much your interest rate and mortgage payment can increase. An initial cap limits how much the rate can change after the fixed-rate period. The periodic cap limits how much it can increase each six- or 12-month period. And the lifetime cap sets a limit on rate increases for the life of the loan.
6. Benefit from Falling Rates Without a Refinance
Of course an adjustable rate mortgage doesn’t just have the potential to adjust upwards. It can also adjust down, meaning that your interest rate could fall if the market index also declines. In such an economic situation, you would benefit from a lower rate and payment, similar to having refinanced, but without the added closing costs and fees.
7. Payments Could Get Smaller
In an economy where interest rates are falling or expected to decline, you benefit by having an ARM. The index affects your mortgage rate which also affects your payment. So an adjustment could mean your monthly payment goes down.
The Drawbacks of Adjustable Rate Mortgages
1. First Adjustment Can Be Steep
One of the biggest drawbacks to an ARM is the potential for the first adjustment to happen in an economy where interest rates have been rising. Interest rates have climbed several points over the past few years, and periodic caps don’t apply to the initial change. This could mean a big and sudden increase in your monthly payment.
2. Rates and Payments Can Rise Significantly Over Time
While periodic caps can help moderate big increases to your rate and mortgage payment, lifetime caps are usually fairly large. It’s not unheard of for an ARM that starts out at 4% to climb to 9% or 10% over the life of the loan.
3. Your Best Laid Plans May Hit a Snag
There is more risk involved for the borrower with ARMs, which is one of the reasons the introductory rates are so attractive. Getting a mortgage with an ARM requires careful planning for when and how you’ll sell or refinance, or how you’ll manage higher payments if you don’t sell. But things don’t always go according to plan, which could mean you have trouble selling or refinancing when you need to.
4. May Be Subject to Negative Amortization
Because of the complexity of some kinds of ARMs, it’s possible to end up owing more money than you did at closing. This is possible due to negative amortization loans, where payments are so low that they only cover a part of the interest due. The remaining interest gets rolled into the principal balance, which could grow over time.
5. Prepayment Penalty
Because many borrowers will sell or refinance before an ARM’s initial adjustment, some ARM loans come with a prepayment penalty. This penalty may apply if you sell or refinance within the fixed-rate period. In some cases, the benefit of a low rate may outweigh the cost of the penalty. In others, you may want to ask your lender for an ARM without a penalty.
6. ARMs Are Complex
For a first-time buyer, the ins and outs of a fixed-rate mortgage can be complicated. ARMs are even more complex. The terms, rules, fees, and structures of ARMs can be difficult to understand. Of course, there may be a way to work within these rules to your benefit. Speaking to a licensed loan officer, in detail, about your needs and options is a must.
ARMs can be a good choice for some home buyers. The added flexibility and savings can help buyers who want to save and invest, and those who plan to move, refinance or sell in a few years. Because of the complexity of ARMs and the variability of the interest rate, these home loans carry a higher risk for the borrower, so it’s important to understand all of the terms and conditions before choosing an ARM.