Learning the pros and cons of adjustable-rate mortgages can help you decide if the benefit of lower interest rates for a specified introductory period works for you. When the introductory period expires, adjustable rates will reset based on a financial index that's connected to your adjustable-rate mortgage, or ARM. Here are a few things to consider when deciding if adjustable mortgage rates are for you.
Pros and Cons of Adjustable-Rate Mortgages
- Pro or Con: Your risk tolerance is important. Adjustable mortgage rates are determined by financial indexes that can change based on factors such as domestic and global economic trends and financial markets. If you can't afford or are concerned about changes in your mortgage payment amount, an adjustable-rate mortgage may not be your best choice. On the other hand, if you're not worried about how payments can potentially adjust, the below-market rates offered for the introductory period of an adjustable-rate mortgage can help make your home purchase more affordable.
- Pro: Rate and lifetime caps limit rate increases. According to Fannie Mae, rate caps and lifetime caps can protect against unrestricted increases in your payments. Adjustable-rate mortgages typically adjust after the introductory period expires and annually thereafter. How your payment will adjust depends on the rate of the financial index associated with your mortgage and the margin amount charged by your lender. Here's a fictional example: Your adjustable-rate mortgage is associated with the PQR financial index that currently has a rate of 2.00 percent. Your lender charges a margin of 0.75 percent. Your adjustable interest rate would be 2.75 percent until the next adjustment period. If your adjustable-rate mortgage has an interest rate cap of 0.50 percent, your payment could not increase by more than 0.50 percent per adjustment period. A lifetime cap would not allow your mortgage rate to rise above a specified amount over the life of the mortgage loan regardless of how applicable financial indexes perform.
- Con: While caps limit rate increases, your mortgage rates may not decrease if index rates fall. Reading the fine print on mortgage documents can be tedious, but this is where your due diligence can pay off. When discussing adjustable-rate mortgages with loan officers, it's important to know what makes payments increase and by how much. It's also important to know if your payments can decrease according to how the applicable financial index performs.
- Pro: Hybrid adjustable-rate mortgages provide lower initial fixed rate payments. A hybrid adjustable-rate mortgage offers an introductory period of fixed rate payments at a rate lower than the market rate for fixed-rate mortgages. Hybrid adjustable-rate mortgages may offer an intro period of one to 10 years and typically adjust when the introductory period expires and annually thereafter. When you shop hybrid mortgages, you'll see them described as 1/1, 3/1, 5/1 and so on. The first number represents how many years the introductory fixed rate will last; the second number is one, which indicates that your mortgage rate will adjust once a year after the introductory period expires. Using a hybrid adjustable-rate mortgage to buy a starter home can help you save on interest if you're planning to move up to a larger home within a few years, but the Consumer Financial Protection Bureau cautions homeowners not to count on selling or refinancing their homes before the introductory period expires.
- Con: Prepayment penalties. Prepayment penalties can reduce or negate potential savings on a hybrid adjustable-rate mortgage if you sell your home or refinance before a date specified in your mortgage documents. Always ask prospective lenders if the loan you're considering has a prepayment penalty.
Depending on your preferences, financial circumstances and goals, the pros and cons of adjustable-rate mortgages can help you see how an adjustable-rate mortgage may work better than a fixed-rate mortgage. Contact a professional financial advisor to learn how an adjustable-rate mortgage can work according to your individual needs and goals.