Why You Shouldn't Be Afraid of an Adjustable-Rate Mortgage
May 17, 2010
Adjustable-rate mortgages (ARMs) are loans with interest rates that can adjust after a predetermined period. During an initial fixed-rate period--which could be one month, one year, three years, five years, seven years, or even ten years--the ARM acts just like a fixed-rate mortgage. After that initial period, the interest rate can adjust, usually tied to the movements of a commonly used financial index.
Because market interest rates as represented by a financial index can change unpredictably, many home buyers fear an adjustable rate. They think that, over time, ARMs will result in unmanageable payments. These fears drive many borrowers to opt for fixed-rate mortgages (FRMs), which have interest rates that don't change during the life of the loan.
Advantages of ARMs: Lowest Mortgage Rates Initially
However, ARMs have some powerful advantages over FRMs. Before you shy away from an ARM, consider the following:
- On average, ARMs carry a lower interest rate in the initial fixed period, which allows you to have a lower monthly payment during that period.
- A mortgage rate in an ARM can adjust both up and down. It doesn't just go up all the time. If interest rates rise during the adjustable period, your monthly payment will go up, but if they then drop, your monthly payment can decrease as well.
In essence, an ARM is a trade-off: It starts with a lower initial rate but carries with it more risks in the future, particularly if you think interest rates are likely to rise after your mortgage rate becomes adjustable.
Keep in mind that your ARM loan will have both a floor rate and a ceiling rate, meaning that it cannot go below a certain level or above a certain level at any time during the loan term. The floor, also referred to as the bottom rate, is typically also the start rate, or the mortgage rate you get when you get the loan. The maximum rate, or ceiling, can be as much as 12 percentage points higher than your start rate--but you will know ahead of time what the maximum and minimum mortgage rates can be, so your highest possible and lowest possibly monthly payments are known ahead of time.
Keep in mind, too, that an ARM can be refinanced when the time for rate adjustment comes. Refinancing to a fixed rate at that time gives you a stable interest rate then, if that's what you prefer. There are typically no prepayment penalties on ARMs, so increased cost should not be a barrier to refinancing.
Deciding Between Adjustable and Fixed Rates
Whether an adjustable-rate mortgage or a fixed-rate mortgage is better for you depends on answers to some questions:
- Is your income high enough to pay adjusted monthly payments if interest rates go up significantly?
- Will you obtain other loans (such as a car loan or home improvement loan) in the future?
- How long do you plan to stay in your home?
- Do you plan to make additional payments to your principal or pay the loan off early?
If you can bear the risk of a potentially high payment in the future--say you expect with near-certainty that your income will rise in future years or you haven't borrowed to your limit in the first place--an ARM may be a very good financing choice for you.
An ARM is also the likelier option for shorter-term situations, such as if you're planning to sell in just a few years. The lowest mortgage rates are going to be found with an ARM loan, so there is no reason to take a higher mortgage rate if you don't plan on keeping the mortgage beyond the initial fixed-rate period. Most American families move well before the 30-year term of most mortgages is up. (Conversely, if you intend to stay in your home for a long time, then a fixed-rate mortgage may be the more attractive option.)
A mortgage lender or mortgage broker will be able to help you determine the best financing options given your circumstances and plans, but understanding how ARMs work--and when they're truly useful--will help you feel comfortable with your decision.
