The adjustable-rate mortgage loan is a rather controversial subject. You may hear some experts tell homeowners they are never a good idea and are simply too risky, but this is only true in certain cases. In some circumstances, ARMs can be a great option for homebuyers, and a trustworthy Loan Officer will be able to help you decide if it is right for you.
What is an ARM?
Unlike a fixed-rate mortgage loan, which has the same interest attached for its duration, an ARM's interest rate is only fixed for a short period of time at the start of the loan. Usually, that period of time is five years. An ARM with a five-year fixed interest rate is referred to as a 5/1 ARM. While a 5/1 is the most common, it is possible to have a fixed rate for a longer period of time. Within that fixed-rate period, the interest on an ARM is generally very low.
After the fixed-rate period ends, the interest rate can change every year. There could be some years where the interest rate rises and others where it falls. Despite the low interest rate during the initial payment period, the uncertainty of what that interest rate could be in a given year is what causes many people to avoid ARMs.
It is important to note, however, that interest rates on an ARM cannot rise and fall indefinitely. Rather, there are often payment caps included that place restrictions on interest-rate increases. Common caps involve restricting how high the interest rate can rise after the initial adjustment period, how high it can rise after the subsequent adjustment periods and also how high a borrower's interest rate can rise over the entire course of the loan.1 If you know the rate caps of a loan you are considering, you can calculate whether you would be able to afford the highest possible interest payment you would have to make.2
The Advantages of an ARM
The main advantage of an ARM is that for the initial payment period of the loan, you are paying a very low interest rate and have much more affordable monthly payments. As a result, you might be able to obtain a bigger loan and purchase a larger house.3 If you are not planning to stay in your home for very long, you can reap the benefits of a large home with low payments without having to pay higher interest rates - as you will probably have moved before the fixed payment period is over.
If you do decide to use an ARM to purchase a home you wouldn't be able to afford with a fixed-rate mortgage, it is important to be prepared for the possibility you end up unable to sell your home before the initial payment period ends. As stated above, you'll want to work with your Loan Officer to figure out the highest possible rates you'd have to pay and determine whether it is a risk you are in a position to take.
Another advantage: You could end up paying lower interest rates once the fixed-payment period is over. It all depends on the state of the market, and in certain instances an ARM can save homeowners a lot of money. Again, make sure you will be in a position to pay if the opposite occurs.
The Disadvantages of an ARM
The main disadvantage of an ARM is its instability. It is difficult to budget for interest payments when you won't know what they'll be, and that can cause some homeowners substantial anxiety or lead to situations where they are unable to make their full monthly payments. This is why the ARM is best for those who understand the risks and know they are in a position to afford making higher monthly payments if they kick in.
Is an ARM Right for You?
There are two groups of people best suited for an ARM: those in strong financial standing and those who plan to move after a few years. Those who do not have the financial security or prefer a more stable lifestyle - such as homebuyers with children who want to be able to plan for the future and make sure their monthly payments won't become unaffordable - are better off with a fixed-rate mortgage.3 Those who think the uncertainty would simply make them too anxious may also want to stick with a fixed-rate mortgage.
When used wisely, an ARM can be a great way to save money. Just make sure your ARM loan package is not set up so the initial monthly payments are the highest you can afford.4 Otherwise, it might be difficult for you to make on-time payments if your interest rates rise.
Sources 1Consumer Financial Protection Bureau 2U.S. News and World Report 3NerdWallet 4Smart Asset