Why You Should Consider an Adjustable-Rate Mortgage

by Michael Kling on 15 August 2013 3 comments

Adjustable-rate mortgages, or ARMs, may be coming back into style.

If interest rates rise as they are expected to, ARMs, also sometimes called variable-rate or floating-rate mortgages, may become more popular among both homebuyers and homeowners who missed fixed-rates at their record low. ARMs received a bad rap in recent years, since many home loans that defaulted in the housing crash were ARMs. However, many of those loans were subprime mortgages given to borrowers with poor credit, little home equity, and questionable incomes, while today's lending standards are much stricter. (See also: 7 Financial Must Haves for the First-Time Home Buyer)

Maybe ARMs deserve a second chance.

"Arm" Yourself With Financial Basics

First, some ARM basics. The interest rates of ARMs change periodically usually based on an index, such as the Prime Rate or a Treasury bond rate. That means your monthly payment may go up or down. Is that risky? Yes. But the trade-off is the introductory low rate that can help you qualify for a home loan and move into the home you want.

Most ARMs today are technically "hybrid ARMS." They entail an introductory period with a low fixed rate, typically between two and seven years. After that initial period, the rate adjusts periodically based on its index.

Common hybrid ARMs are the 3/1, 5/1, or 7/1. The first number indicates how long, in years, the initial fixed rate lasts. The second shows how often the interest rate changes. When the loan adjusts — usually upward — after the initial period, it is said to be fully indexed.

ARMs offer lower interest rates and smaller monthly payments over the near term and the risk of higher rates in the future. Generally speaking, the shorter the initial fixed-rate term, the lower its rate.

Important Terms to Know

Before we look at seven reasons to choose an ARM, let's look at a few key terms.

Index

The index is a benchmark measure for rates in general. Lenders have used the one-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR).

Margin

The margin is added to the index to determine your mortgage rate. It depends on the lender, but it usually stays the same. For instance, if the index was 3% and your margin 1%, your rate would be 4%.

Cap

The cap is how much the rate can increase when it adjusts.

Lifetime Cap

The lifetime cap is how much the rate can increase over the life of the loan. Look at this to consider the worse-case scenario. A common rate cap for a 5/1 ARM is 2/2/6, which means it could increase up to 2% in the first adjustment, up to 2% in following adjustments, and up to 6% over the life the loan.

Payment Shock

Payment shock is what happens when your mortgage payment jumps when the rate is adjusted. Before signing the loan documents, run through the numbers by talking to a loan officer or using an online calculator at BankRate or Zillow to get an idea of how rate increases will impact your monthly payment.

7 Reasons Homeowners Might Choose an ARM

Despite the negative press, an ARM might be the right choice for many homeowners. Consider these seven reasons why.

1. You Expect to Earn More

If the loan resets into a higher rate, you'll be able to easily afford the larger monthly payment with your increased earnings.

2. You Expect to Sell Before the Rate Increases

Perhaps you expect a job relocation or plan to renovate the home and sell it for a higher price. While you're living in the home, you can take advantage of the lower ARM rate without worrying about where rates will head in a few years.

3. Your Family is Growing

Your family will grow within a few years, so you will move into a larger home anyway.

4. You have Poor Credit, but You Are Fixing It

If you repair your credit in a year or two, you can refinance into a new mortgage and qualify for a lower rate.

5. You Expect Home Prices to Rise Out of Reach

You want to grab the home of your dreams before the price is out of reach but can't qualify for a fixed-rate loan.

6. You Have a Crystal Ball

You've peered into the future and you know that interest rates will drop or remain low when your loan adjusts.

7. You Expect a Windfall

Your intention is to pay off the loan early because you have an inheritance coming or a plan to win the lotto.

Of course, those last two aren't prudent financial decisions. Nevertheless, if rising rates do make your payment unbearable, and it turns out that you don't win the corner office, and your scheme to win the lotto doesn't work out, you can always refinance into another loan as long as home values don't crash. And that's not likely to happen, is it?

Have you considered an ARM? Would you ever consider an ARM after the housing bust?

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Kostas

Well, ARMs have always been an interesting option, but I guess that it is easy to understand why many decide to stay away. You really need to have a bit of an idea about finances on the grander scale and that is something that many do not have.

Guest's picture

I would never consider an ARM. It is not because of the math behind it (which can make sense), it is because of the difficult to measure component called "risk." The possibility of interest rates rising, job loss, and the illiquidity of a home are the primary factors. Why take on the risk when you don't need to by locking in a fix rate mortgage. If the rates go up, you have a relatively low rate compared to the market. If rates go down, you can refinance.

Guest's picture

Although I believe that ARMs are usually not as good as fixed mortgages, my first mortgage was an ARM and it worked well for me.

Because I paid quite a bit extra each month, the principal went down quickly. When the rate adjusted, even though the rate increased, my monthly payment decreased. The reduced principal was stretched through to the remaining years left in the mortgage, so the P&I lowered. I was very thankful for this reduced monthly payment during a period of extended unemployment.

Do ARMs have their risks? Absolutely. But if you are disciplined enough, you can benefit from them as well.