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Is an Adjustable-Rate Mortgage the Right Choice for You?

ARM mortgage

Financing a home loan may feel like the least sexy aspect of house hunting, but it’s potentially one of the most important decisions in the entire process. How you finance your home could affect years of your financial future, so understanding your available options is very important.

Adjustable- vs. fixed-rate mortgages

Most buyers will have a choice between a fixed-rate loan and an ARM (adjustable-rate mortgage) loan. In a fixed-rate mortgage, the interest rate and monthly payment stay the same for the entire term of the loan. This type of loan makes it easy to budget and provides stability in payment terms, no matter what happens to the market.

With an ARM loan, the interest rate adjusts over the life of the loan, which could cause your monthly payment to change. Your rate (and payment) could go up or down, making it a riskier option for buyers. It can be hard to predict how your loan will adjust, and buyers who aren’t prepared could feel blindsided when the rates shift upward.

How ARM rates are determined

Lenders set ARM rates using an index and a margin. Common indexes include the London Interbank Offered Rate (LIBOR) and the Cost of Funds Index (COFI). The margin is the amount the lender adds to the index to arrive at your loan rate. So a loan based on an index at 3% with a margin of 2 percentage points would have a fully indexed rate of 5%.

The ARM starts with an introductory period when lenders offer an initial rate (sometimes called a teaser rate) that is typically lower than one you’d get with a fixed-rate loan. During the introductory period — which could last anywhere from 30 days to 10 years, depending on your lender — the rate stays the same.  

Once that initial period ends, your loan enters an adjustment period. During this time your interest rate and payment could adjust based on the index, which may fluctuate due to economic factors such as unemployment rates, wage growth, inflation, Federal Reserve activity and the bond market. Most ARMs offer an annual adjustment period, meaning your rates only change once a year, but adjustment periods can be more or less frequent. Your lender is required to give you sufficient notice before the initial new payment is due.

Note: Make sure you look at a loan’s APR, not just the initial rate. If the APR is a lot higher than your initial rate, your teaser rate is much lower than your fully indexed rate, so the lender will substantially increase your payment at the first rate reset (even if rates stay stable).

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ARM loans pros and cons

At first glance, many buyers might think a fixed-rate loan is the best option. This may not be true for all potential homeowners. While ARM loans certainly have risks, there are some benefits to this type of home financing.

Pros

  • Lower rate (initially). An adjustable-rate mortgage has a lower initial interest rate (and lower payment) than a fixed-rate loan. This flexibility could allow buyers to save money upfront to prepare for a higher payment later on.
  • Your interest rate could decrease. Fixed-rate loans stay the same even if interest rates drop (though you can refinance for a lower rate).
  • Unique payment options. Some lenders offer various repayment options (such as interest only) during the introductory period of the loan. This could make mortgage payments even lower initially.
  • You may be able to afford more house. Because an ARM offers lower interest rates (and lower monthly payments), you may be able to get more for your money. Buyers who know they are likely to have extra money in their budget when their loan adjusts can use this type of loan to their advantage.

Cons

  • Your interest rate may increase. Once your introductory period ends, your interest rate and monthly payment could increase. Homeowners who don’t prepare for this adjustment could find themselves facing financial trouble. It’s possible for the interest rate on an ARM to go higher than on a fixed-rate loan.
  • Your payment could go up a lot, even if the interest rate doesn’t change. You may have the opportunity to make interest-only payments, which means you only need to pay the interest that has accrued on the loan each month. But when that period ends, you’ll have to start paying down the balance as well, so your monthly payment will increase.  
  • You could end up underwater on your mortgage. It’s possible (especially if you start with interest-only payments) that you could end up in a position where you owe more on your property than it’s worth.
  • Possible prepayment penalties. If you assume you can refinance or pay off the ARM before the adjustment period, you could face complications. Some lenders have a prepayment penalty for hybrid ARM loans, which means you’re stuck paying a fee for refinancing or paying off the loan early.

Preparing for an increase

If you choose an ARM to finance your real estate purchase, make sure you speak with your lender about all the terms in the loan. You’ll also want to make sure you understand how high your loan rate and payment could get. The interest rate ceiling is a legal requirement that sets the maximum an interest rate can reach for a loan. It’s a cap to limit the amount your loan can increase. ARMs may also have an interest rate floor, which is the lowest your rate could go. If you still feel comfortable taking on the loan once you know how high your rate and payment could go, this type of loan could be a good fit.

At the very least, you should have a plan for handling higher payments if your rate goes up.

Who is the best fit for an ARM?

An ARM loan can be a great way to save money and increase your buying power, but the downsides might be a deal breaker for risk-averse buyers.

“If you get a fixed loan, you know what your payment is going to be, guaranteed,” said Tendayi Kapfidze, chief economist at LendingTree. “The big risk you take [with an ARM] is that you could end up with a high payment when it resets.”

If you are considering an ARM, ask yourself these questions to determine whether it’s a good fit for your situation:

  1. Do you plan to move or refinance before the interest rate adjusts? It may be worth opting for an ARM if you know you will sell the property before your rate adjusts. Make sure that you won’t incur prepayment penalties (or can afford them), and consider what you’ll do if you can’t or don’t sell your home before the adjustment occurs.
  2. Can you afford the higher payment? If you can already afford a higher mortgage payment, but you’d like to save some money upfront, an ARM can be helpful. You can set aside the difference in a savings account, use it to pay off debt or invest the money elsewhere.
  3. Do you expect your income to increase? If you can reasonably expect your income to increase before the adjustment period, you may be able to get into a larger home faster. But if your income doesn’t increase or you experience a hardship, an increased interest rate could make it more difficult to keep up with your house payments.
  4. Do you plan to take on more debt? If you plan to take out loans for a car or education, will the payments on these new debts make it more difficult to afford a higher mortgage payment if your monthly bill increases?

The Consumer Handbook on Adjustable-Rate Mortgages offers a chart (Page Nos. 5 to 8) that you can use to help compare different ARM options and fixed-rate payments. You can fill in each box to help you identify which is the best fit for your situation.

 

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