3 Times an Adjustable Rate Mortgage Makes Sense
Written by
Daria Uhlig
Edited by
Amen Oyiboke
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More homebuyers are turning to adjustable-rate mortgage loans to keep their payments affordable. It’s easy to understand why.
The average rate for a 5/1 adjustable-rate mortgage (ARM) is 5.51%, compared with 6.33% for a 30-year fixed-rate conventional loan, according to the Mortgage Bankers Association’s most recent Weekly Mortgage Applications Survey. On a $400,000 loan, that difference translates to about $210 in monthly savings with an ARM.
ARMs begin with a fixed interest rate, followed by periodic adjustments. A 5/1 ARM, for example, has a fixed rate for the first five years, then adjusts annually. A 7/1 ARM offers a seven-year fixed period before yearly adjustments begin.
Despite caps on how much the rate can change with each adjustment and over the life of the loan, a rate adjustment can leave you with a larger payment than you anticipated. But used strategically, an ARM can also save you a lot of money.
3 Times When an ARM Makes Sense
Here are three situations that could make an ARM the best choice for financing your home purchase.
Interest Rates Are High
No one can predict what interest rates will do in the long term, but the current rate environment gives you a good sense of whether or not an ARM will benefit you. Freddie Mac recommends considering an ARM when rates are comparatively high.
You Plan To Sell Your Home Before the Loan Adjusts
ARMs usually offer low teaser rates that can save you a lot of money compared to fixed-rate loans. Selling before the rate adjusts lets you take the money and run, so to speak.
You Can Refinance Before the Adjustment
If rates fall to a point or two below your teaser rate, refinancing into a fixed-rate loan locks you into a lower rate sooner. Likewise, refinancing when rates are starting to climb can protect you against a large upward adjustment.
Tips for Reducing Risks of an ARM
Follow these tips to keep rate adjustments from overwhelming your budget.
- Understand how points are applied. Points are interest paid upfront in exchange for a lower rate. The Consumer Financial Protection Bureau warns that the rate reduction usually applies only during an ARM’s fixed-rate period. Use an online mortgage calculator to determine whether you will break even before the rate adjusts.
- Look for a conversion option. Some ARMs allow borrowers to convert to a fixed rate after a certain period. You’ll likely pay a fee to convert, but it may still save money if you have many years left on the loan.
- Only accept a fully amortizing loan. This means you pay both principal and interest each month, so the loan is paid off in full by the final scheduled payment, with no balloon payment required.
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