Adjustable rate mortgages or ARMs are a different kind of mortgage than the standard 15 year or 30 year loans available at your local credit union.
ARMs have a lot of negative stigmas attached to them, but are there situations where using an adjustable rate mortgage is a wise financial move?
Pros and Cons to Having an Adjustable Rate Mortgage
Before you jump onto the adjustable rate mortgage train, consider the following:
What is an Adjustable Rate Mortgage?
Most of the mortgages now available post-financial crisis are less risky investments for the lenders.
Gone are the days of getting a mortgage without income documentation. The most common loans are 30-year fixed loans and 15-year fixed loans. Fixed rate loans give stability to the payment for the borrower. Your mortgage is $800 today, $800 tomorrow, and $800 10 years from now. The stability in the payment makes it a lot easier to plan for your financial needs for years to come.
ARMs are different in that they have a fixed rate portion for a set period of time. After that period of time the rate can adjust up or down based on the wording in the mortgage document.
A common ARM is the 5/1 ARM. The first number, 5, means the quoted rate is fixed for five years. After 5 years the loan adjusts the interest rate once per year. This means your rate could go up, costing you more money each month, or down, making your payment smaller. It all depends on the rate adjusts.
This adds some uncertainty and risk to a product that most people prefer to be fixed rate. The draw? Lower interest rates.
The Upside to Using an Adjustable Rate Mortgage
1. Lower Starting Interest Rate
The biggest upside to using an adjustable rate mortgage over a fixed rate mortgage is the interest rate will be lower on the ARM than on the fixed rate.
For example, currently the 30 year mortgage rate is averaging about 3.47% across the country. In contrast a 5/1 ARM’s average rate is just 2.61%. That’s a difference of 0.86% — and that difference can save you a ton of money in interest over the life of the loan.
2. Lifetime Caps
Another upside is most ARMs now have lifetime caps on how high the interest rate can rise. That means you can plan for how high it could get and decide whether or not the loan makes sense for you.
3. Your Rate Can Drop
Lastly, one of the best things about adjustable rate mortgages is what happens when interest rates go down. You can watch your ARM rate adjust down, taking your monthly payment down as well. Alternatively you could leave your monthly payment the same and just end up paying extra on the loan.
The Downside to Using an Adjustable Rate Mortgage
Despite there being some upsides, there are some significant risks to using an adjustable rate mortgage.
Risk and Reward
The first is the trade of risk and reward. As with any other investment decisions, deciding to risk a potentially higher future interest rate in order to get a lower rate (and payment) today is risky considering the current financial climate. Home mortgage rates are at historical lows; lows that are kept there in part to financial gaming of the monetary system by the government. Sure, trimming 0.86% off of your home loan rate would be fantastic — if it lasted. Since ARMs can adjust upwards you can quickly have an interest rate that is above today’s current fixed rate loans.
Selling Before Rates Rise
One perk that is mentioned for ARMs is they are great for homeowners that don’t plan to be in the homes long enough to feel the pain of the potentially higher adjusted rates. Meaning they will sell the home within a short period of time to avoid adjustments. These perks make no mention of the cost of selling a home — about 6% in realtor costs — wiping out the lower interest rate savings.
Refinance When Rates Rise
Another perk that is used to support getting an ARM is the fact you can always refinance out of your ARM if rates start to rise. This is where many buyers were trapped during the financial crisis — they wanted to refinance but couldn’t afford to, or the value of their home dropped significantly and they suddenly had less than the 20% equity needed to refinance. (Or in many cases, were in the negative on equity. Either way they couldn’t refinance.)
Relying on your ability to get out of the loan in order to justify getting into the loan should be a warning flag to you.
Lifetime Caps are High
Lifetime caps on the interest rate are mentioned above as a positive. However, those caps are often astronomical. Having your interest rate rise from 2.75% to 8% over a few years would ruin most families. If the caps were lower it might make sense to try an ARM, but with a cap spreading over 5% or more there is significant financial risk.
That’s not to say an ARM wouldn’t work for you. You just need to understand all of the variables.
Final Thoughts on ARMs and if They Make Sense
If rates were significantly higher today for 30-year or 15-year fixed rate mortgages, a better case could be made for trying an ARM. When rates are high and dropping then it makes sense not to lock into one rate for the entire life of the loan. You want to have your rate drop over time.
However, in today’s current economic environment rates have only one direction to go: up. Locking in a fixed rate mortgage will cost you less than 1% more on your APR, but the cost is well worth it when you can lock in that rate for the next 30 years.