When An Adjustable-Rate Mortgage Is The Best Choice

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When An Adjustable-Rate Mortgage Is The Best Choice

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There can be some mystery surrounding an adjustable-rate mortgage, or ARM. This type of mortgage typically begins with an interest rate that is fixed for a period of time—usually three to 10 years—and then adjusts based on an index, a benchmark interest rate to which the ARM is tied, plus a fixed margin set by the lender. This unpredictability makes ARMs a riskier choice than fixed-rate mortgages, which charge the same interest rate for the duration of a loan.

Your lender will tell you which index your ARM follows, but common indexes include the London Interbank Offered Rate (LIBOR) and the 1-year Treasury yield.

Fixed-Rate vs. Adjustable-Rate Mortgage

The definition is in the name: The interest rate on a fixed-rate mortgage remains unchanged during the loan term. Fixed-rate loans are best “for homebuyers who plan to be in their home for a long period of time or indefinitely,” says Matthew Posey, certified mortgage planning specialist with Axia Home Loans in Austin, Texas.

ARMs typically offer a fixed rate for a set period of time, then can adjust periodically throughout the remainder of the term. ARMs are great if you anticipate staying in your home for no longer than the fixed-rate period.

How an ARM Works

ARMs are usually defined first by the length of the fixed-rate term, then by how often the rate can reset after the fixed-rate period ends. “For example, with a 5/1 ARM, your interest rate will remain the same for the first five years and then can adjust each year after that until your loan is paid off,” says Nadia Aziz, general manager of home loans at online real estate company Opendoor. The interest rate adjustment is based on the index the ARM is tied to. If the index falls, your interest rate will decline—and vice versa.

While interest rates can increase or decrease based on the index, some ARMs offer both a ceiling and a floor for interest rates. “Also, while adjustments to the interest rate typically happen once a year after the initial fixed-rate period, some ARMs adjust more frequently, which can cause volatility in your monthly mortgage payment,” Aziz says. “Make sure you fully understand all of these aspects of the mortgage you are considering.”

Types of ARMs

There are two primary types of adjustable-rate mortgages, but you’ll find differences even within mortgage types, including:

Hybrid ARMs. Hybrid mortgages have a fixed-rate period, followed by an adjustable-rate period during which the interest rate can increase or decrease. You’ll pay both the principal and interest throughout all periods. Some common hybrid ARMs include 3/1, 5/1, 7/1 and 10/1—meaning they offer a fixed rate for three, five, seven and 10 years, respectively, with rate adjustments allowed once every year thereafter. Other hybrid ARM options exist but are less popular, such as a 5/5 ARM, which has an initial, five-year fixed-rate period and then transitions to an adjustable-rate phase in which the interest rate adjusts once every 5 years.
Interest-only ARMs. Borrowers pay just the accrued interest on their mortgage during an initial interest-only period. Initial payments are typically lower than they would be with other types of mortgages. “It’s important to note, though, that if you’re paying interest only, you’re not paying down the overall amount borrowed (or the principal), so payments following the (interest-only) period will be significantly higher to account for both the principal and interest,” Aziz says. Like a hybrid ARM, interest-only ARMs often include a fixed-rate period.

Who an ARM Is Right For

Most ARMs allow for flexibility and lower payments during the initial fixed-rate period, so this type of loan can be ideal for homebuyers who plan to stay in a home for just a short period of time.

“For example, if you have a high likelihood of relocating after four or five years, choosing a 5/1 hybrid ARM could be a wise financial decision and save you thousands of dollars over what you’d pay with a traditional fixed-rate mortgage,” Aziz says. ”You should also consider whether, based on your current or expected future financial situation, you would be able to afford the higher payments when the rates adjust.”

When You Should Choose a Fixed-Rate Mortgage

The risk comes when the fixed-rate term expires and the payment adjusts. Some borrowers are not prepared for the higher payment when it happens.

“In a world of inflation, with cost of living increasing and wage stagnation, many choose to use the ARM to purchase a more expensive property due to the lower rate and payment during the fixed term,” says Aaron Chapman, branch manager of SecurityNational Mortgage Co. in Mesa, Arizona. “The fixed option in my opinion is always better because there is no surprise in the payment adjustment and the payment actually diminishes over time because of inflation.”

If you plan to stay in your home for a longer period of time, then a fixed-rate mortgage generally is the best option. In a high-rate environment, a fixed-rate mortgage may be more difficult to qualify for because of the higher monthly payments. That, of course, isn’t an issue now because interest rates are at record lows.The average 30-year fixed-rate mortgage is cheaper today than a 5/1 ARM by about a tenth of a percentage point.

Adjustable-Rate Mortgage Benefits

You can secure a lower interest rate. The enticing low interest rates of an ARM can be the gateway for buying the home of your dreams. If you know you only will be in the home for a short time, this is a good bet. “Adjustable-rate mortgages are often paired with borrowers who only plan on staying in their home for less than 10 years on average,” says Jason Sorochinsky, vice president of mortgage lending at Digital Federal Credit
Union. For instance, he says, you may have an employment contract with a university or college as a professor that spans five years.
You could pay off your mortgage quicker. Barring prepayment penalties, a lower interest rate may enable the borrower to pay more of the principal on the loan. This can save hundreds, or even thousands of dollars in interest.
The market could work in your favor. Down the line, your mortgage could adjust to a lower rate. Borrowers also can refinance their mortgage if they notice market conditions are favorable. Keep in mind, though, that mortgage rates currently are at all-time lows.

Adjustable-Rate Mortgage Drawbacks

Your loan payments may increase. After the introductory interest period ends, and if market conditions cause interest rates to rise, your monthly loan payments could increase. This boost in interest may make it more difficult for you to afford your mortgage payments.
Your budget hinges on uncertainty. Because there will be fluctuations, ARMs mandate that borrowers plan for significant rate increases, which would boost your monthly mortgage payments. Refinancing could be an option, but it’s hard to predict what interest rates will be and if you can qualify for better rates. Some borrowers may face foreclosure if they can’t keep up with the inflated payments.
There’s fine print to decipher. If you don’t understand an ARM’s fine print and complexities, borrowers can be caught off guard when the teaser rate ends and a higher interest rate kicks in. You may also face repayment penalties should you want to sell the property or refinance. You should negotiate this type of exit strategy without penalties with your lender before accepting this type of loan.

Editor in Chief for Forbes Marketplace U.S. Mike Cetera contributed to this article.

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