You may know what a stress test is in a medical context -- an examination of your body's performance under physical strain. Since the 2008/2009 financial crisis, the concept has also been frequently applied to banks, as regulators have evaluated them based on how they would perform under adverse market circumstances. You can take this same stress test approach to evaluating what kind of risk you would be facing if you took on an adjustable rate mortgage.
An adjustable rate mortgage, or ARM, can save you money by getting you a lower interest rate for your loan. Under certain circumstances though, an ARM could cost you money in the long run by subjecting you to higher interest rates later on, and potentially put your house at risk by making your loan unaffordable. A stress test can help you evaluate whether the money-saving potential of an adjustable rate mortgage is worth the risk.
The Pros and Cons of ARMs
To see one potential benefit of an ARM loan, you just have to look at recent mortgage rates. According to mortgage finance company Freddie Mac, at the end of November of 2014, the average 5/1 ARM mortgage rate was nearly a full percentage point lower than a 30-year fixed mortgage rate. The average 1-year ARM mortgage rate was more than 1.5 percent lower than the 30-year fixed rate. The difference is that the 5/1 ARM rate would not reset for five years (and then annually after that) while the 1-year ARM rate could reset every year.
In a different mortgage rate environment, another potential benefit of ARMs is that they could allow your mortgage rate to drop over time if market rates fell, without requiring you to refinance. However, this benefit has greater potential when interest rates are relatively high; in today's low-rate environment, they don't have much room to fall.
Today's low-rate environment heightens the potential risk of an ARM. Because rates have been unusually low, they are more likely to rise than they are to fall. If interest rates rise steeply enough, having an ARM could cause you to pay more interest over the full term of the loan than you would have with a fixed-rate mortgage, and could push your monthly payments to the point where they are unaffordable.
Thus, the pros and cons of an ARM boil down largely to a trade-off between lower initial mortgage payments and the risk of higher payments later on.
The ARM Stress Test
To evaluate this trade-off, you should do an ARM stress test. ARM loans have specific terms for how soon the rate can reset initially, how frequently they can reset thereafter, and by how much the rate can reset each time. Use a mortgage calculator to figure out what would happen to your monthly payments if the maximum rate reset occurred every time possible. Then look at both those rising monthly payments and what they would do to your total interest payments over the life of the loan. This is your ARM under maximum stress.
You can then compare that worst-case scenario with what you would pay if your ARM rates stayed low, and with what you would pay if you opted for a fixed-rate mortgage instead. You will then be in a position to judge whether the potential savings of the ARM outweigh the risk.
One benefit of this approach is that it will lead you to take a careful look at all of the detailed terms of any ARM you are considering. In the process, it will also give you a feel for what the ARM could do to your payments in different scenarios, and whether or not your budget could handle the stress.