Adjustable Rate Mortgage Pros and Cons
Adjustable Rate Mortgage Pros
Low Initial Interest Rate
The initial interest rate for an adjustable rate mortgage is typically lower than the rate for a 30 year fixed rate mortgage. With an ARM, the interest rate is typically fixed for the initial three, five, seven or ten years and then is subject to change semi-annually or annually for the remainder of the 30 year loan term. The mortgage rate during this initial period of time for an ARM is lower than the rate on a fixed rate or interest only mortgage and is sometimes called a starter or teaser rate because it entices borrowers. The low initial mortgage rate for an ARM can make getting a loan and buying a home more affordable as compared to other programs.
Lower Initial Monthly Payment
A lower initial interest rate with an ARM means a lower initial monthly mortgage payment. A lower mortgage payment saves you money on total monthly housing expense and enhances your financial flexibility when you buy a home or refinance. Although the monthly mortgage payment for an adjustable rate mortgage can change and increase over the life of the loan, a lower initial payment can provide additional financial breathing room when borrowers need it most.
Afford Larger Mortgage Amount
The lower initial interest rate and monthly payment for an ARM potentially enables borrowers to qualify for a larger loan amount as compared to a fixed rate mortgage. A lower mortgage rate allows borrowers to afford more mortgage while a higher rate reduces what size loan you can afford. For example, a .5% reduction in interest rate could increase the mortgage amount you qualify for by tens of thousands of dollars. The ability to qualify for a larger loan is especially helpful for borrowers looking to stretch their mortgage dollars to buy a nicer home.
Good for Borrowers Who Will Own Home for a Set Period of Time
If you know you are only going to own your home for a set period of time, such as three-to-ten years, then an adjustable rate mortgage may be the right financing option for you. In this scenario you benefit from the lower initial interest rate and monthly payment during the initial period of the loan when the rate does not change, but you are not exposed to the risk that your rate and payment increase during the adjustable rate period of the loan. That is why an ARM may be a good option for people buying a starter home that they intend to own for less than five years. In this case, the borrower can obtain a 5/1 ARM which offers a set interest rate and payment for the first five years of the loan before converting into an adjustable rate mortgage.
Potential for Mortgage Rate to Go Down
Another benefit of an adjustable rate mortgage is that your mortgage rate could go down if interest rates decrease. During the adjustable rate period of an ARM, your interest rate is usually subject to change on an annual or semi-annual basis. Your mortgage rate during this period is called the fully-indexed rate and fluctuates based on an index, which is a rate such as LIBOR or the treasury rate that changes based on economic factors. If the index goes up, your mortgage rate goes up but if the index decreases, your rate goes down. A lower mortgage rate reduces your monthly payment and saves you money on interest. It is highly challenging to predict how interests rates will change several years in the future but an ARM provides the potential for your mortgage rate to decrease if interest rates fall.
Adjustable Rate Mortgage Cons
Less Certainty and Peace of Mind
The main downside of an adjustable rate mortgage as compared to a fixed rate loan is that an ARM involves greater risk, lower certainty and less peace of mind. With a fixed rate mortgage, your interest rate and monthly payment are set and cannot change over the life of the loan, even if mortgage rates increase significantly. With an ARM your rate and monthly payment can increase which can put borrowers in a challenging financial situation. Borrowers should understand the significant financial risks associated with an adjustable rate mortgage before selecting one for their mortgage.
Potential for Mortgage Rate to Increase
As mentioned above, the interest rate for an adjustable rate mortgage is subject to change annually or semi-annually and possibly increase significantly during the adjustable rate period of the loan. Your interest rate during the adjustable rate period is calculated based on an underlying index which can increase depending on economic conditions. If the index jumps significantly, your mortgage rate increases as well. Although ARMs have caps which limit the increase in rate during any single adjustment period and over the life of the loan, your rate can still go up dramatically. For example, the life cap for an ARM, or the amount by which your mortgage rate can increase over the life of your loan, is usually 5.0%. That means that if your initial teaser rate is 3.0%, you could end up paying an 8.0% mortgage rate over the course of your loan if interest rates go up. Borrowers should review our explanation of the downside of an adjustable rate mortgage (ARM), when the mortgage rates increases as much as possible as quickly as possible, to understand the worst case scenario for an ARM.
Possible Spike in Monthly Mortgage Payment
With an ARM, a significant increase in your mortgage rate results in a spike in your monthly mortgage payment. Although your interest rate and monthly payment only change every six months or a year, borrowers may be caught off guard by a sudden increase in their monthly payment. In the most drastic scenario, your monthly payment could more than double when your mortgage rate adjusts and you may not be able to afford the new, higher payment. While this scenario is unlikely borrowers should be aware of potential payment shock over the course of their mortgage before selecting an adjustable rate mortgage.
More FREEandCLEAR Resources
Review our comprehensive overview of how an adjustable rate mortgage works including key program terminology, reasons to select and ARM as well as informative charts and examples.
Use our Adjustable Rate Mortgage Calculator to determine your initial payment, future payments and worst case scenario for an ARM based on numerous factors including interest rate, fixed period length, index, margin and adjustment caps.
Review adjustable rate mortgage rates in your area based on fixed rate period, discount points, credit score and other inputs. Comparing ARM mortgage rates from multiple lenders is the best way to find the loan with the lowest rate and costs.
Compare adjustable rate (ARM), fixed rate and interest only mortgages including key features such as monthly payment, interest rate and risk level to determine the program that meets your personal and financial objectives.
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