5 Ways an ARM Could Be Better Than a Fixed-Rate Mortgage
1. You plan to move before the adjustment period
ARMs are structured by a fixed period followed by an adjustment period. During the fixed period, you’ll have a set amount of time (such as 5, 7, or 10 years) that your interest rate will not change. Your monthly mortgage payments are consistent and known ahead of time, just like a fixed-rate mortgage.
It’s not until the adjustment period begins that rates fluctuate with the market. Caps reduce the risk of significant rate increases, but even a slight increase can lead to higher monthly payments and more interest paid overtime.
But if you know this is a starter home or your goal is to fix and flip the property, an ARM can work to your advantage. If you treat the low introductory rate like a fixed-rate mortgage and then either pay off or sell before it becomes variable, then the risk of a rate increase becomes irrelevant.
Let’s pretend you get one of the most common adjustable rate mortgages, a 5/1 ARM. Your interest rate will be fixed for five years and then become variable, recalculating once per year for the remainder of the loan. That means you have five years to sell if, for example, you plan to move across the country.
Sometimes even the most well thought out plans can go awry, so it’s important to understand how your mortgage works and the options you have available. It’s always possible to refinance if you decide to stay and want to lock in a rate for the remainder of the loan.
2. You’re confident your income will increase
A low rate is important if you need the lowest monthly payments possible in order to afford your home. A temporary low rate can create affordable payments that will get you through the current circumstances. Some lenders even offer interest-only loans, where your monthly payments only consist of interest and you pay the principal in bulk later on.
Does your career have a clear path with increased earning potential? Or, do you know your household income will double when your youngest child starts school and both parents are able to rejoin the workforce?
While nothing is certain, there are situations where you can confidently assume your income will grow as years go byIf low monthly payments are a top priority, an ARM may be the answer. A 10/1 ARM would give you a decade to become financially prepared for the possibility of a higher payment, should your rate rise at that time.
3. You want to pay extra on the principal
Even if you can afford higher monthly payments, the low introductory rate of an ARM may be part of a strategy to attack your loan principal.
As a refresher, your mortgage payments include both principal and interest. Principal is what builds your home equity, while interest is a fee for borrowing money. The bulk of your monthly payment goes toward interest during the early part of your loan. The further you get through the loan, the more of your payment applies to the principal.
Want to build equity faster than what will happen automatically? It’s possible by making extra payments on the principal – either regularly or as occasional lump sums. So if you have a low introductory interest rate with a 7/1 ARM, you could leverage the savings by paying extra toward your principal every month. By the time you reach the variable period, you’ve knocked off thousands from your principal – significantly reducing how much you’ll pay in interest by the time you have a fully amortized loan.
4. All signs point to interest rates dropping in the future
Mortgage rates over time naturally rise and fall. People often zero in on the negative potential for ARM rates to rise. But let’s not forget that the opposite is also possible: A variable rate could actually lead to savings if rates drop when you reach the adjustment period.
Say you get a 5/1 ARM when rates are rising. This allows you to lock in a lower than average rate and reap savings for up to 60 months. Nobody has a crystal ball, but experts use historical data and economic trends to predict the timing of when rates will rise and fall. If all signs point to falling rates as you near the end of your fixed-rate period, you can ride the wave into further savings.
Even if rates fall, not everyone is comfortable with their mortgage payment being at the mercy of market changes. For instance, if you get a 7/6 ARM, your rate could change six times per year!
A popular solution in this case is to refinance. Once rates drop, you can refinance into a fixed-rate mortgage and never have to worry about fluctuations for the remainder of the loan.
5. You need a jumbo loan
Are you shopping for luxury homes or looking at an area with a high cost of living? You may be a candidate for a jumbo loan, which simply means it’s too large to conform to the rules of conventional mortgages.
Because jumbo loans aren't guaranteed by Fannie Mae or Freddie Mac, lenders view them as riskier and can make them harder to qualify for. But if you can meet the stricter standards, you’ll likely benefit from a lower interest rate. That matters in any mortgage, but it’s especially impactful if you’re paying interest on a property worth $650,000 or more.
Jumbo loans can be fixed or variable. You’ll often find jumbo ARM introductory rates to be better than their fixed counterparts. Just remember to think about those fundamentals – your budget, how long you plan to keep the house, and whether you’re willing to refinance for a fixed-rate down the road.
The right choice for you
There’s no one size fits all when it comes to interest rates on home loans. Shop around, understand your options, and don’t be afraid to ask questions. Like a good friend, a good lender will help you make a wise purchase.