What is an Adjustable-Rate Mortgage?
Tired of renting, but not sure you want to stay in one place forever? An adjustable rate mortgage can give you a low monthly payment so you can build some equity up front. We’ll tell you all about it on this page. Not looking for a treatise on the subject? Contact us at home.loans by clicking below and we can give you the low down, one-on-one.
Adjustable-Rate Mortgage Basics
Adjustable-rate mortgages (ARMs) are home loans with interest rates that are “variable” or susceptible to change throughout the life of the loan. ARMs were the stuff of nightmares for a lot of mortgage lenders and Realtors. In fact, anyone who was working in or near the real estate industry during the mortgage crisis of the mid 2000s is likely still irrationally afraid of these products. The truth is that they’re not all bad, if you’re paying attention, and they do serve a purpose for a certain subset of homeowners.
You’ll find that adjustable-rate mortgages usually offer lower initial rates that are often locked in for anywhere from one to 10 years, giving you time to buy a home that you know won’t be your last, save some money on interest and maybe even gain a bit of home equity in the meantime. If you do decide to stay in your house long term, you can always try to refinance your adjustable rate mortgage into a fixed rate loan.
Popular adjustable rate mortgage products include:
These “hybrid” ARMs are a combination of fixed and adjustable interest rate structures. Each product has an introductory period of a fixed interest rate that lasts for a set number of years. This is represented by the first number (i.e. the 3/1 arm has an introductory fixed rate period lasting 3 years). After the initial fixed rate period ends, the interest rate becomes adjustable. During the adjustable period, the interest rate can be changed or “reset” at predetermined intervals. In the case of these particular hybrid ARMs, the rate may be adjusted every year (annually). There are a plethora of hybrid arm products on the market with different values for their initial fixed rate periods and their adjustable periods (i.e. 10/1 ARM, 1-Year ARM, 3/6 ARM, etc.).
Pros and Cons of Adjustable-Rate Mortgages
Adjustable rate mortgages aren’t the monsters they’ve been made out to be. They can be really useful when used properly, but that’s the trick. Here are some pros and cons to consider:
Drawbacks of Adjustable Rate Mortgages
Longer term interest rates can be very high. Keeping an ARM for the long term is a bad idea. Although they generally have a cap on how high the interest can climb, that number is often quite high.
After lock expires, payment can be unstable. Unless the payment on your adjustable rate mortgage is very comfortable, you’ll need to have a plan to deal with it before the lock expires. Otherwise, you’re going to be dealing with a payment that may change frequently.
There’s no guarantee you can refinance. Counting on the ability to refinance is great and all, but there’s never a guarantee. In 2006, no one knew they’d lose so much equity practically overnight. Without some equity or cash on the table, a refinance will be difficult or impossible.
Benefits of Adjustable Rate Mortgages
Low initial interest rate. The initial interest rate on an adjustable-rate mortgage is always extremely attractive. Who wouldn’t want a rock-bottom rate on their mortgage?
Rate lock options as long as 10 years. If you don’t plan on paying off your mortgage, then an adjustable rate mortgage could work in your favor. Just choose a lock period that corresponds to the length of time you plan to be in your home before you sell.
Low upfront payments. Lower interest makes for lower payments. That’s money you can put toward extra principal payments or, you know, a new iPhone.
Who’s the Ideal Borrower for an Adjustable-Rate Mortgage?
Borrowers who will benefit from an adjustable-rate mortgage will tend to be experienced home buyers with nerves of steel. They can handle the risk involved with these products and understand how to use them to their advantage. They tend to:
Have significant cash reserves.
Keep on top of their credit file.
Be able to refinance on a whim.
Make significant sacrifices to increase their personal wealth.
This is not to say that the only people who should use an ARM are cash-heavy, sacrificial credit idolizers, but it doesn’t hurt. ARMs are tricky and have to be watched carefully or they’ll sneak up on you and you’ll never see it coming. A lot of first time home buyers have been bitten by them because no one prepared them for the loan they were getting. With adequate planning, a first timer can absolutely do well with an ARM, but you’ll want to put some money back into savings and make sure your credit remains stellar so you can refinance if your mortgage rate starts to climb precipitously.
Adjustable-Rate Mortgages: In Review
Adjustable-rate mortgages can be an easy way for borrowers to get into a lower rate mortgage for a shorter term, but make very poor long term mortgage instruments. If you can pay your home off in under 10 years, however, they’re certainly an option to consider. Make sure the ARM you’re securing matches the lock term you think you’re getting. For example, a 10/1 ARM is an ARM that’s locked for 10 years, with the rate changing every year thereafter. The shorter the lock period, the better the rate but the bigger the risk to you.
Also, it might help to know that there are adjustable-rate mortgages insured by the Federal Housing Administration (FHA). Like other FHA mortgages, these home loans often have lower down payment and credit score requirements, and may also be offered at a lower initial interest rate.
Adjustable rate mortgages aren’t for everybody, but they might be right for you. Still not sure what kind of loan is a good fit? Contact us! We’re right here at home.loans waiting for you, and boy are we really tired of playing Angry Birds.