April 13, 2024

Pros And Cons Of An Adjustable-Rate Mortgage (ARM) – Forbes Advisor

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Adjustable-rate mortgages, or ARMs, are an alternative choice to conventional mortgages. They’re advantageous in certain situations, but compared to their fixed-rate counterparts, their unique interest rate structure can be difficult for some borrowers to understand.

How Does an Adjustable-Rate Mortgage (ARM) Work?

An adjustable-rate mortgage is a home loan with a variable interest rate. This means your ARM rate can change every few months or annually, depending on your terms. A fixed-rate mortgage, on the other hand, has one set interest rate that doesn’t change for the life of your loan.

The most common form of an ARM is a hybrid ARM, where you pay a fixed interest rate for a set amount of time—usually the first few years of your loan—and then the rate adjusts regularly thereafter. These adjustments are based on a market index—the Secured Overnight Financing Rate (SOFR) being the most common for adjustable-rate products—that your lender uses to set and follow rates. There are a few different indexes, and the benchmark index rate your lender chooses might be different from what another lender chooses.

ARM rates can go up or down based on those benchmarks, but they also come with caps that limit how much they can increase at every adjustment date and over the course of the loan. There are three types of caps to be aware of:

  1. Initial adjustment cap. The initial adjustment cap is the maximum amount your interest rate can increase at the first adjustment following the loan’s fixed-rate period. It’s often set at 2%.
  2. Subsequent adjustment cap. The subsequent adjustment cap is the maximum amount your interest rate can increase at all the adjustments after the first adjustment. It’s typically set at 2%.
  3. Lifetime adjustment cap. The lifetime adjustment cap is the maximum amount your interest rate can increase over the life of the loan. It’s often set at 5%.

Adjustable-Rate Mortgage Example

One of the most common types of ARMs is the 5/1 ARM. The first number, five, is how long the fixed interest term will last on your loan. This means you’ll pay the same interest rate for the first five years of your loan. Then, the rate adjusts every year after that, which is what the second number indicates.

There are also options like 5/6 or 7/6 ARMs. With these options, you’ll pay the same rate for the first five or seven years of the loan. Afterward, the rate adjusts every six months.

Related: Is Now A Good Time To Get An ARM?

Pros of an Adjustable-Rate Mortgage

There are certain features that might entice you to choose an ARM over a fixed-rate mortgage.

Low Initial Fixed Rate

If your ARM follows the more popular hybrid model, you’ll pay the same low fixed interest rate for the first several years of your loan. This can save you a lot of money if you plan to only stay in your home for a few years and want to take advantage of the lower rate while you live there.

Lower Payments

ARMs generally have lower interest rates, at least initially, compared to fixed-rate mortgages. A lower interest rate means a lower payment. You can use those extra funds to pay off other debt, invest in your future or make larger payments on your mortgage principal to pay off the loan faster.

Rate Caps

The interest rate on your ARM can only increase by so much. This means even if mortgage rates are on the rise and you’re set to get an increase, it won’t go up an exorbitant amount. Ask each lender to explain what kind of interest rate cap structure it uses for its ARMs as you shop around.

Cons of an Adjustable-Rate Mortgage

While ARMs can serve you well in specific situations, they come with some notable disadvantages as well.

Interest Rates Can Go Up

An interest rate bump means your monthly payments will increase. If you don’t think you can comfortably afford the new monthly payment once the adjustment goes through, you may have to cut costs in other areas.

Limited Availability

Not every lender offers adjustable-rate mortgages, and those that do may not have the exact terms you’re looking for.

Harder To Budget For

Fixed-rate mortgages are pretty straightforward. Since the rate on a fixed-rate mortgage doesn’t change, you won’t have to worry about your monthly payments changing. This makes them easy to budget for.

That’s not the case with ARMs. Once the ARM’s fixed-rate period ends, changes happen periodically and what you pay one month could increase the next month. These regular adjustments can be harder to predict and budget for, so an ARM may not be a good option if, for example, you have an unpredictable income or struggle with budgeting in general.

Is an Adjustable-Rate Mortgage Right For You?

You might be a good fit for an ARM if you:

  • Want to capitalize on a lower starting interest rate
  • Don’t expect to live in your house for the entirety of your loan or plan to refinance before the fixed period ends
  • Can comfortably afford changes to your home loan payments

You may want to skip an ARM if you:

  • Are on a fixed budget with little to no wiggle room for major changes
  • Don’t like significant changes to your home loan, especially if it’s already difficult to afford
  • Plan on living in your home for most of the loan period

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