Adjustable-Rate Mortgages are Growing in Popularity: Is One Right for You?

There’s a lot of hype in the news these days regarding adjustable-rate mortgages. Why all the attention? At first glance, they seem like a great deal. The initial interest rates on adjustable-rate mortgages are usually extremely low when compared to fixed-rate mortgages. But these types of home loans have considerable downsides, too. Before you feel too tempted by those initial low interest rates, look past the hype and figure out if getting an adjustable-rate mortgage (ARM) will help or hurt you. To do so, you need to understand exactly what ARMs are (as well as the different types), who can really benefit from them, and who should stay away. By the time you’re done reading, you should know if an ARM is the right choice for you. What Is an ARM - and How Is It Different from a Fixed-Rate Mortgage? The difference is in the name. With a fixed-rate mortgage, you’re locked in at a certain interest rate for the life of the mortgage (unless you choose to refinance, of course). With an adjustable-rate mortgage, you’re eligible for what seems to be a too-good-to-be-true interest rate right off the bat. Here’s the catch: that interest rate will change periodically throughout the life of your loan, depending on the terms of that loan. When the interest rate on an ARM changes, it usually jumps to a dramatically higher rate. Because of this, ARMs can end up costing more over the lifetime of your loan than a fixed-rate home loan. There are different types of ARMs: hybrid, payment-option, and interest-only. Hybrid ARMs typically come with an initial interest rate period. If you’ve seen ARMs classified as 5/1, 3/1, or 7/1, that means the initial interest period will last five, three, or seven years (respectively). After that period, the interest rate will adjust once every year after (hence the “1”). Payment-option ARMs let you decide how you want to pay. You can choose to pay the interest only, the interest and a little bit of the principal balance, or the interest that has accrued in the past month. This tends to be risky if you take the easier financial route today and pay as little as you’re required. Most people tend choose to pay the smallest amount possible – or the minimum payment – leaving them with no equity in the home and a growing loan balance. An interest-only ARM is also an option for potential borrowers. Again, by paying only the interest you won’t be building any equity in your house – and you’ll still have the principle of the loan to worry about. But, you will have a lower payment until the mortgage resets. It’s worth noting that some of these mortgages can reset depending on the specific terms of your loan, which means required payments will increase substantially after a certain amount of time. Who Stands to Benefit the Most from an ARM: The Positives Due to the fact that ARMs have an initial interest period, those that stand to benefit the most from an ARM are those that know they’ll be moving before that initial interest rate expires. Homeowners that know they can afford to pay off their home quickly and have a plan in place to do so can also benefit. If you’re 100 percent sure you’ll be relocating in three to five years, then an ARM might prove advantageous. You’ll have fewer costs associated with the purchase of the house. And because you’ll look to move relatively soon after buying, it’s unlikely that building equity in that particular property is a priority for you. It won’t matter if you’re paying just the interest on the home loan. Younger individuals that haven’t reached their full income potential might also benefit from an ARM. The payments on ARMs are lower to start with at the beginning of the lifespan of the loan. Those with lower incomes will be able to qualify for larger loans upfront. It’s great for those that expect to make more in the coming years, but aren’t quite there yet. If you’re an investor that knows they won’t be holding onto a home for a while, ARMs could provide a better option than fixed-rate mortgages as the adjustable-rate loans come with lower payments. When it comes to investment properties, you want to keep as much of your money as possible! Why Caution Is Needed - The Negatives The biggest negative to ARMs is the lack of stability that fixed-rate mortgages offer. Uneducated buyers will find themselves faced with sticker shock when the initial interest rate disappears. You need to be certain that you can afford the ARM past that initial period – even if you don’t ever plan to pay it because you want to sell the property before that period expires – or you might find yourself struggling to make payments. Even though ARMs might be great for those expecting to earn more at a later date, basing a house purchase off of projected income isn’t the financially responsible choice. Unfortunately, we need to consider that job loss does happen. You may not get that raise you were so sure you had in the bag. There are a slew of other unforeseen factors that could affect your ability to afford your mortgage. If the initial interest rate looks extremely attractive now, 5 years into the future you might come to regret your decision. Just because you can afford an ARM based off the initial interest rate doesn’t mean you’ll be able to afford it after that interest rate adjusts. If you would rather have the peace of mind that comes with having a stable, predictable mortgage, ARMs are not for you. You’re better off enjoying the security of the slightly more expensive fixed-rate mortgage. A mortgage loan is a huge responsibility, and it’s important to think things through before committing. Run the numbers past the initial interest rate period to ensure you can afford the house you’re interested in buying.