Adjustable rate mortgages (ARMs) offer borrowers multiple benefits including a lower initial interest rate and monthly payment, the ability to afford a larger mortgage and the potential for a lower payment if rates decline in the future. An ARM is a good financing option for borrowers who know they are only going to own their home for a specific number of years or if you think mortgage rates are going to drop in the future.
These benefits, however, come with certain risks and borrowers should fully understand the downside of an adjustable rate mortgage before selecting their loan program. In short, the initial interest rate and monthly payment for an ARM are usually fixed for the first 3, 5, 7 or 10 years of the loan but after this initial period, the mortgage rate and monthly payment can change and possibly increase significantly for the duration of the mortgage. For example, with a 7/1 ARM, your mortgage rate and payment do not change for the first seven years of the loan but then is subject to adjust and potentially increase annually for the remaining 23 years. This potential jump in monthly payment, also called payment shock, is the main downside of an adjustable rate mortgage.
Borrowers on a tight budget or with limited financial resources may struggle to pay a higher monthly payment. Depending on your specific loan terms, your monthly payment could more than double over the course of your mortgage. While this is a drastic scenario, it is possible with some Adjustable Rate Mortgages and borrowers should be aware of this potential risk. Failure to pay your mortgage could result in penalties, default and potentially foreclosure. Borrowers who were enticed by the lower initial monthly payment of an ARM may end up struggling financially later in the loan.
The table shows initial interest rates and closing costs for adjustable rate mortgages. The interest rate for an ARM can potentially increase in the future and may be much higher than the rates shown in the table over the course of your loan, which can result in payment shock. If you are comfortable with the risk of an ARM we recommend that you shop multiple lenders to find the best loan terms, like you would for any other type of mortgage.
The financial consequences of payment shock can be very serious so you should understand both the best and worst case scenarios for an Adjustable Rate Mortgage to ensure that it fits your risk profile and financial objectives. The worst case scenario example below highlights the risk of an adjustable rate mortgage to enable borrowers to make an informed decision when they select their mortgage program.
Simply put, the downside of an ARM is the risk that your interest rate and monthly payment increase suddenly and significantly during the adjustable rate period of the loan. For example, economic factors could cause a spike in interest rates that causes your monthly payment to jump. Depending on your loan terms and market conditions, this could happen in year 10 of the loan or in year 22, which underscores the uncertainty of an ARM. It is simply impossible to predict when and by how much your rate and payment can increase in the future.
Because there are so many different outcomes, one way to understand the downside of an adjustable rate mortgage is to look at the worst case scenario which is what the example below does. The example compares the worst case outcome for a 7/1 ARM to a 30 year fixed rate mortgage. The example uses following assumptions:
The example uses a 7/1 adjustable rate mortgage so the interest rate and monthly payment are fixed for the first seven years of the loan and then subject to change and increase in year eight and for the remaining 23 years. The initial fixed period or teaser rate for the first seven years is 2.750% and the maximum interest rate is 7.750% based on adding the life cap (5.000%) to the fixed period rate (2.750%). By comparison, the fixed rate mortgage is much simpler with a 4.000% mortgage rate that remains unchanged over the 30 year loan term.
The chart below compares the monthly mortgage payments for the adjustable rate mortgage (red line) and fixed rate mortgage (blue line) over 30 years. During the first seven years, the fixed rate or "teaser" period, the interest rate of 2.750% and monthly mortgage payment of $1,551 for the ARM are lower than the interest rate of 4.000% and payment of $1,814 for the fixed rate mortgage.
As illustrated by the chart below, beginning in year eight, the interest rate for the ARM increases significantly to 7.750%, the maximum possible increase at the first adjustment period. In this worst case scenario, the rate remains at 7.750% for the remaining 23 years of the ARM, the adjustable rate period. Based on the higher rate, the monthly payment for the adjustable rate mortgage increases to $2,465 for the remainder of the loan as compared to the $1,814 constant payment for the fixed rate mortgage. The payment for the ARM jumped by nearly $1,000 which could place significant financial strain on the borrower in this example.
In addition to paying a much higher monthly payment for 23 years, the ARM requires the borrower to pay $157,584 more in total interest expense over the life of the loan as compared to the fixed rate mortgage. Although this example is unlikely and represents the absolute worst case scenario, it does an excellent job of highlighting the downside of an adjustable rate mortgage.
Watch our Adjustable Rate Mortgage instructional video to understand the risks of an ARM.
Adjustable Rate Mortgage (ARM) Overview Instructional Video
"Fixed Rate and Adjustable Rate Mortgages." FDIC. Federal Deposit Insurance Corporation, October 14 2016. Web.