The Pros and Cons of Adjustable-Rate Mortgages
If you’re trying to buy a home, one of the biggest hurdles you’ll probably need to clear is financing your purchase. Fortunately, homebuyers have numerous options, including traditional fixed-rate loans and less common adjustable-rate mortgage products.
What’s an adjustable-rate mortgage?
Adjustable-rate mortgages—commonly called ARMs—are home loans with a variable interest rate. The initial rate is fixed for a predetermined period, usually five or ten years. After that, the borrowing rate on the remaining balance is reset periodically, using current interest rates.
ARMs are also called floating mortgages or variable-rate loans. During the housing market crash in the mid-2000s, ARMs were blamed as a contributing factor. Since then, they have been re-engineered and subject to tighter regulation and lending standards.
Is a variable-rate loan right for you? It depends. Here are several of the most significant pros and cons when comparing ARMs to fixed-rate loans.
Advantages of ARMs
1. Lower initial interest rate.
ARMs are offered at attractive rate discounts to help lure borrowers and reward them for assuming the risk of rising rates. So if you plan to sell your home before the rate resets in, say, five, seven, or ten years, an ARM could provide an excellent tool for reducing your borrowing costs.
2. You might be able to borrow more.
Lower initial payments may translate into qualifying for a larger loan. With skyrocketing housing prices in many markets, buyers may be attracted to creative ways to get into a house and save money on monthly payments.
Lower monthly payments can translate into options to use your “extra” cash in other ways. For example, you could make additional payments to reduce your loan balance and build more equity. Plus, if your rate is reset, it will be based on a lower outstanding principal.
4. Payments may go down.
If you’re locked into a fixed-rate mortgage, you’d have to refinance your loan to take advantage of falling interest rates. You’d need to shop around and select a lender, then pay substantial fees to process the loan. It may take several years to recoup your closing costs.
In contrast, ARM borrowers don’t need to lift a finger or pay a penny to benefit from lower interest rates. Instead, their monthly payments will automatically decrease when the rate resets.
Disadvantages of ARMs
1. Payments may increase.
Of course, interest rates can also rise, which would result in higher monthly payments once an ARM enters the reset period. Depending on how your loan is structured, the changes could be dramatic, creating serious budgeting problems.
Once the initial fixed interest rate period passes, ARMs can be reset as often as every six months, making it difficult to budget for future monthly payments accurately.
To reduce the impact, make sure your ARM includes rate caps. Periodic caps limit the amount your rate can change in one period, whereas lifetime caps limit rate revisions over the life of the loan.
3. Prepayment penalties.
ARMs can be ideal for borrowers who expect to move again before facing the risk of higher rates. However, some ARMs include prepayment penalties. So when shopping around, make sure your borrower won’t charge a fee if you decide to sell or refinance your home.
As a rule, ARMs are more complicated than traditional fixed-rate mortgages. Therefore, as a borrower, it’s essential to evaluate these products carefully. Ask your lender to explain all the potential risks before deciding if a variable-rate loan is right for you.