Is an Adjustable Rate Mortgage (ARM) Right For You? If you're looking to purchase a…
Is an Adjustable Rate Mortgage (ARM) Right For You?
Is an Adjustable Rate Mortgage (ARM) Right For You?
If you’re looking to purchase a home or refinance your current mortgage, you’ll need to decide whether an adjustable rate mortgage (ARM) is the right loan for you.
These loans often offer lower initial interest rates than fixed-rate mortgages, which can save you money. However, be sure you understand how they work and what’s involved before making a decision.
How an Adjustable Rate Mortgage Works
An adjustable rate mortgage, or ARM, is a type of home loan that changes interest rates after an initial fixed period. These types of loans are popular among homeowners, especially those looking to save money in the long run.
Generally, ARMs come with an initial introductory period of 5, 7 or 10 years, during which your rate is fixed for the entire duration of the loan. After that, your rate will adjust periodically based on a market index or margin (a number of percentage points added to an index) chosen by your lender.
The lower introductory rate is often very attractive to first-time buyers, who are typically offered a significant discount. According to Freddie Mac, the average five-year ARM rate was 1.01% lower than a 30-year fixed-rate mortgage at the end of July 2022, which means that homeowners could be saving $183 per month on a $300,000 mortgage over the life of an ARM.
However, ARMs can be risky for some borrowers. When the rate adjusts at the end of the fixed period, your payment can increase. When the rate increases, the payment re-amortizes the balance of the mortgage over the remaining term of the loan at the new rate. A higher rate can mean a higher payment.
Another is prepayment penalties, which can occur if you choose to refinance or sell your home before the introductory period ends. Not all ARMs had a pre-payment penalty, so be sure to ask your lender if your loan has that feature.
Pros
Whether or not an adjustable rate mortgage (ARM) is right for you depends on your goals, budget, and comfort level with the unpredictability of variable interest rates. But the low initial introductory rates offered by some ARMs can save homebuyers a lot of money, especially in the first few years.
While they’re often viewed as risky, ARMs have been reformed since the 2008 financial crash. Today’s ARMs offer more reasonable, transparent terms, making them a safer option for homebuyers.
For instance, many ARMs have caps on how much your rate can rise throughout the mortgage, so you won’t be hit with huge increases like those that led to foreclosures in 2008.
These ARMs can also be a good fit for people who plan to sell their home before the rate adjusts to higher levels. They can also be a great choice for homeowners who have extra cash on hand and want to pay off their principal balance faster.
Cons
Adjustable rate mortgages (ARMs) are a great option for homebuyers who want a low interest rate and flexibility. But they can also be risky if you don’t know what the future holds.
ARMs typically offer lower initial interest rates than fixed-rate loans, but they can change during the life of your loan based on market conditions. This can leave you with higher monthly payments if rates increase during your adjustable-rate period.
You can avoid this by saving money to account for the possibility of higher rates and making extra payments on your principal balance during the fixed-rate period. It’s also a good idea to get preapproved for an ARM before you start searching for your dream home.
ARMs got a bad reputation in the real estate crash of 2007 but they’ve cleaned up enough to be an attractive choice for many homeowners. But beware: Some ARMs have nasty “fine print” that can make them a financial disaster. Be sure to work with a trusted mortgage lender who will explain all the ins and outs of an ARM before you make a decision on which loan is best for you.
Bottom Line
An adjustable rate mortgage (ARM) is a type of loan that fluctuates in interest rates based on prevailing market conditions. These loans are often cheaper than fixed-rate mortgages, but they come with some drawbacks.
The main drawback is that your payments could increase if interest rates rise. This is why many people prefer fixed-rate mortgages.
Another disadvantage is that some ARMs can have prepayment penalties. This means that you may have to pay a fee if you refinance or sell your home before paying off the loan.
In addition, some ARMs can have negative amortization. This is when your monthly payment owes more in interest than the amount you actually pay off the loan.
ARMs are now popular again even though they got a bad rap during the real estate crash of 2007, but their revival proves that these loans can be useful for borrowers who want to take advantage of low rates and/or plan to stay in their homes for a short time.
