An adjustable-rate mortgage’s interest rate can fluctuate, but the interest rate on a fixed-rate mortgage stays the same. Typically, ARMs begin at a lower interest rate than those of fixed-rate mortgages, but when the introductory period of an ARM ends — between one month and five years or more — the rate will likely go up and so will your payment.
The rate you pay is tied to a wider interest rate measure called an index. When the index goes up, so will your payments. When it goes down, your payment might increase unless there’s a cap on how high your rate can go up over the life of the loan.
Find out the pros and cons of adjustable-rate mortgages and decide if this kind of home loan is right for you. Then, find the best mortgage lender to begin the process of buying a home.
ARMs: The Pros and Cons
Here’s a quick look at the major benefits and drawbacks of using an adjustable-rate mortgage:
Pros of Adjustable-Rate Mortgages
- You’ll benefit upfront.
- Your interest rate might decrease.
- You might qualify for more house.
- Your payment might decrease.
- You might have flexible payment options if you choose a pay option ARM.
Cons of Adjustable-Rate Mortgages
- You could be left with a much higher payment.
- You might buy more house than you can afford.
- Budget and financial planning is more difficult.
- You might end up owing more than your house is worth.
Keep reading to learn more details about each of the pros and cons of an ARM home loan so you can better decide if it’s the right type of mortgage for you.
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Advantages to Adjustable-Rate Mortgages
An adjustable-rate mortgage can offer a number of benefits that could complement your financial strategy. Here’s a closer look at the advantages of this kind of loan:
You’ll Benefit Upfront
Because an ARM interest rate is typically lower than a 30-year fixed-rate mortgage, you’ll benefit from this kind of loan upfront. You’ll also benefit if you refinance or sell the house before the initial rate on the ARM goes up at the end of the fixed-rate period.
Your Interest Rate Might Go Down
If you’re gambling on current market conditions changing and interest rates coming down, an ARM might be a good choice for you. When interest rates drop, your mortgage interest rate will likely decrease, which will result in lower monthly payments.
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You Could Buy a More Expensive House
Because ARMs generally feature a lower introductory interest rate than fixed-rate mortgages, your payments will be lower also. You might use the factor of lower payments to your advantage and buy a larger house, a house with upgraded finishes or a house that’s both larger and has higher-end features.
Your Payment Might Decrease
An ARM can also benefit you if you choose to make extra payments toward the principal balance of your loan. When you pay extra toward the principal, you will decrease the overall loan amount. Then, on your next “reset” date for the ARM, your monthly payments might decrease based on the new, lower principal amount you owe.
ARMs Feature Flexible Payments
ARMs often come with flexible payment options that enable you to pay off your mortgage more quickly or slowly. For instance, if you can’t handle a full payment, you might be able to make an interest-only payment, which can allow you keep your mortgage current. Or you can pay more than the monthly payment to decrease the principal balance of your loan.
Adjustable-Rate Mortgage Cons
Before you commit to an adjustable-rate mortgage, understand the drawbacks to this kind of home loan:
Interest Rates Could Go Up
You might expect interest rates to drop, but they could always increase, which would affect your ARM negatively. A higher interest rate could make your monthly payment go up substantially after the fixed-rate portion of the loan is over, which could cause you not to be able to afford your mortgage payment.
You Might Buy Too Much House With an ARM
The flip side of being able to buy a bigger home with an ARM is that you might go overboard. If you buy too much home and your interest rate increases, you might not be able to afford the payments. It’s a good idea to be prepared to make a monthly payment based on the maximum interest rate that you could pay according to your loan agreement.
An ARM Makes It More Difficult to Budget
Because ARM interest rates fluctuate, it might be difficult to budget and make long-term financial plans. You can’t predict what the future will bring regarding interest rates, so it’s tough to know how much you’ll have to spend each month should things change.
You Could Owe More Than Your Home Is Worth
If you always choose the lower payment option on your ARM, it could end up badly; you might even find yourself “upside down” — owing more than your home is worth. Although lower payment options can be tempting, try to pay as much as you can each month.
Types of ARMs
Different types of ARMs exist:
- Interest-only adjustable-rate mortgage
- Option adjustable-rate mortgage
- Hybrid adjustable-rate mortgage
An interest-only ARM requires you to pay only the interest due on the loan for a fixed term, which is typically between five years and seven years. Once the term is over you can either refinance or start paying both principal and interest.
An option ARM’s interest rate adjusts as interest rates change, typically each month. This type of ARM, however, gives you a range of monthly payment options to choose from, including minimum and interest-only payments as well as payments based on a 15-year or 30-year amortization of your mortgage. Option ARMs tend to be complex, so make sure you understand all your options before you make a choice.
A hybrid ARM features a fixed interest rate for an initial period followed by regular, predetermined rate adjustments. For instance, you might get an ARM with a three-year, five-year or seven-year fixed interest rate period followed by annual adjustments.
When ARMs Are a Better Choice
When it comes to ARM versus fixed-rate mortgage options, you’re likely a good candidate for the former if you don’t plan on living in your house forever. It’s senseless to pay for a 30-year, fixed-rate mortgage if you plan on moving in seven years.
Other good candidates for ARMs include those who want to borrow more than their area’s loan limit. Fixed-rate pricing tends to deteriorate with jumbo loans — the difference between a fixed-rate loan within loan limits and one outside the limits can be as high as 1.50 percent. Jumbo ARM interest rates often beat fixed-rate mortgage rates by 2.5 percent or more.
If you like knowing what you’ll be paying each month on your mortgage, you might be better off with a fixed-rate loan. If interest rates go up, you won’t have to worry about it because yours is locked in. Fixed-rate mortgages are best if you think you’ll be staying in your house for a long, long time.
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