If you’re shopping around for a mortgage, you may be attracted to below-average rates advertised for adjustable-rate mortgages (ARMs). You’ve also heard there’s reason to be wary of ARMs. This naturally raises the question: Is an adjustable-rate mortgage a good idea? Or, more specifically, when is an ARM a good idea?
First: Are adjustable-rate mortgages bad?
Let’s start with the elephant in the room. ARMs earned a bad reputation coming out of the 2008 financial crisis because too many variable-rate mortgages were approved for borrowers who should not have qualified for the loans. The resulting defaulted loans were a contributing factor in the financial crisis, and it’s questionable whether the ARMs’ reputation fully recovered.
Rest assured, additional oversight and improved qualification practices make the ARMs of today different from those of a generation ago. Lenders work with borrowers choosing an adjustable-rate mortgage to ensure they understand how ARMs work and they aren’t taking on too much risk.
Why would you choose an adjustable-rate mortgage?
Adjustable-rate mortgages can be a great idea for the right person and situation. Here we’ll explore how an ARM works and why there are some advantages over their fixed-rate counterparts. A few reasons to choose an ARM:
Take advantage of low introductory rates
Contrary to what the name implies, adjustable-rate mortgages actually start with a fixed-rate period for a set amount of time – often three, five, seven, or ten years. This initial rate is typically lower than you would receive with a traditional fixed-rate mortgage.
There are many reasons borrowers look for low interest rates. A low rate can:
- Reduce monthly mortgage payments
- Cost less over the life of the loan
- Help you build equity faster
- Boost eligibility for a higher-priced property
Reduce risk of increases with rate caps
When the fixed-rate period ends, an ARM transitions to a variable-rate period. That means your rate begins to fluctuate based on the current index rate for an ARM. The frequency of the adjustment is based on your type of ARM. For example, a 7/1 ARM will have a fixed period for seven years and then adjust annually.
While it’s true your rate can increase, Most ARMs come with caps to protect you from dramatic rate increases. They help to limit your risk of sudden large payment increases due to rising rates. There are three main caps that may be available:
- Initial Adjustment Cap: The maximum a rate can increase when transitioning from the fixed-rate period to the adjustable-rate period
- Subsequent Adjustment Cap: The maximum a rate can increase after each adjustment period
- Lifetime Adjustment Cap: The maximum a rate can increase above the initial fixed rate for the life of the loan
When is an adjustable-rate mortgage a good idea?
Want to enjoy an ARM’s low intro rate while minimizing risk? Here are three scenarios to consider.
1. When you plan to sell before the fixed-rate period ends
An ARM can be an excellent option if you don’t plan to own the property for the long term. Real estate investors, people who fix and flip houses, and primary homeowners who sell every few years have all discovered ARMs as a smart financial tool. And with some fixed-rate periods lasting up to ten years, there’s plenty of time to find a buyer. Bear in mind, the rate will be higher if it’s not a primary residence.
2. When you refinance before the rate becomes variable
Signing on the dotted line for a 30-year mortgage can feel like a huge commitment – and it is – but it doesn’t mean you have to keep that same mortgage for the full term. Refinancing has become extremely common, especially when rates start to fall or when an ARM’s fixed-rate period ends. Many borrowers prefer to lock-in at a comfortable rate, even if it’s higher than the intro rate, so they don’t have to worry about fluctuations for the rest of the loan term.
3. When you reevaluate before each adjustment
If you’re comfortable with some risk, you may prefer to stay in your ARM beyond the fixed-rate period. It’s possible that rates will be dropping when that time comes, and you could have substantial savings over the life of the loan. You could also sell or refinance when it seems rates start to rise again.
So: When is an adjustable-rate mortgage a good idea?
Fixed-rate mortgages tend to be popular when rates are low. But when rates are rising or your goal is to secure the lowest rate possible, ARMs may be an attractive option. These adjustable loans can save the borrower thousands over a fixed-rate. An ARM could be your best option if you are a homeowner who will move within the next three to ten years.