Buying a first house is an exciting and nerve-wracking process. Not only are you picking the place to call home for life’s next chapter, but it’s also one of the biggest and most financially burdensome undertakings most people experience. Very few individuals or families have the money to purchase a house or condominium outright, which is why most homeowners end up with some type of mortgage. In fact, residential mortgage debt in the U.S. totaled $11.92 trillion in 2022.Citation
While most mortgages are fixed-rate mortgages, which feature an unchanging interest rate over a set period of time, adjustable-rate mortgages (ARMs) also make up a significant portion of the residential market. Many associate ARMs with the subprime mortgage crisis of the late 2000s. However, as the name makes clear, most of the mortgages that went underwater were subprime mortgages, meaning they were taken out by people with poor credit who often put little to nothing down. Many were also option ARMs, which allowed for negative amortization, further compounding the issue.Citation
In this blog post, we’ll discuss what an ARM mortgage is, go over adjustable-rate mortgage pros and cons and share suggestions to help you get the most out of your mortgage.
What is an Adjustable Rate Mortgage?
As the name suggests, ARMs feature an interest rate that can go up or down over the life of the loan. Today, most ARMs are hybrids, featuring an initial fixed period or teaser rate, typically for anywhere from one to five years, followed by a period where the rate can fluctuate according to market conditions as measured by a major index. These indexes, such as the 11th District Cost of Funds Index, are independent assessments of the economy’s performance. Typically speaking, when times are good, they go down, and when times are tough, they rise.Citation
To mitigate rapid changes in the marketplace, hybrid ARMs typically feature caps that limit how much your rate can change over a given period of time. Caps also apply during the initial adjustment, every time a period ends and over the course of the loan’s lifetime. The caps and period lengths will be in your initial loan documents.
Adjustable-rate mortgage examples of this structure are 3/1 ARMs where the first adjustment takes place three years after the loan is taken out, with further adjustments annually, and 5/6 ARMs with an initial adjustment after five years and further changes possible every six months. The first number represents when the initial adjustment occurs with the second number specifying the periods at which future adjustments can occur. It is important to note that when the second number is six, it means six months. All other numbers represent years.Citation
Adjustable-Rate Mortgage Pros
When you ask many people for adjustable-rate mortgage pros and cons, they’ll immediately start talking about the subprime crisis and tell you to steer clear. However, today’s hybrid ARMs have advantages that simply weren’t present back then, adding considerably more weight to the pro side.
General Pros
Lower Initial Interest Rates
Adjustable rate mortgages typically come with lower initial interest rates than their fixed-term counterparts because the adjustable rate fluctuates with the market, helping the lender hedge against a future rise in interest rates.
Lower Monthly Payments
Along with the lower starting payments, there is always the possibility that your payment could drop in the future. This increases your time value of money and potential overall expenditure.
Greater Affordability or Buying Power
With lower interest rates and monthly payments present, your buying power increases. This can be used to purchase a more expensive residence or help bring the overall cost down.
More Flexibility
The lower initial payments afforded by an ARM allow for greater flexibility to adapt to changing circumstances that may arise in the future. This is particularly true of adjustable-rate mortgages with longer initial rate periods.
Pay the Principal Down Faster
Lower starting interest rates create a situation where more of each payment goes to the principal. Extra funds can also be applied toward the principal to decrease the number of future payments.
Situational Pros
Home is a Short-Term Investment
If you only plan on owning your home for a short amount of time, an ARM could be right for you due to the lower initial interest rate. This will save you money without the risk of an upward adjustment as you’ll likely be selling your residence before one can occur.
You Plan on Paying the Home Off Quickly
Similarly, the lower starting interest rate is beneficial if you plan on paying off your home before the fixed-term ends. The lower payments will free up more money to pay off the principal in advance, decreasing the overall cost of ownership.
Projected Greater Payment Ability After the Fixed Term Ends
While there is some risk associated with the fixed-term ending, this can be mitigated if you foresee having a greater ability to pay by the time it does. Future promotions, inheritance or other forms of cash influx can make an ARM a great option.
Projected Holding or Lowering of the Current Index Rate
ARMs can end up being even cheaper than fixed-rate mortgages after the initial period if the index rate holds or lowers. This would make your effective rate at or below the initial one, which should have started lower than fixed-rate alternatives.
Plan to Refinance Before the Fixed Rate Period Ends
Refinancing your home is always an option. If you refinance before the starting period ends, you avoid the cost of any potential increase in interest rate, thus saving you money.
Adjustable-Rate Mortgage Cons
While the pros can be persuasive, there are cons that must be considered as well. For people in certain situations, these disadvantages should be dispositive. Others might not find them so. Regardless, it’s important that everyone keep these cons in mind when considering ARMs.