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Jun 2017

When You Should Consider an Adjustable-Rate Mortgage

There are so many things to consider when you’re planning to buy a new home – the location, style of the home, new vs. old and more. But arguably one of the most critical aspects of buying a home is the process of obtaining a mortgage, and there are two financing options from which you’ll need to choose – adjustable-rate and fixed-rate. Below, we’ll focus on the adjustable-rate mortgage and what considerations you should make before choosing this option.

What is an adjustable-rate mortgage?

An adjustable-rate mortgage (ARM) comes with an interest rate that fluctuates throughout the life of the loan. You may be wondering why anyone would want to choose an option where the payment amount is variable, but one of the selling points of an ARM is the fact the interest rate will usually start out lower than a fixed-rate mortgage. After the initial interest rate period, though, the rate can change – up or down – based on predetermined intervals.

Initial rate period

This is where you’ll likely see the biggest advantage of an ARM – with an introductory interest rate for a certain amount of time (varies by loan/lender) that is often lower than a fixed-rate mortgage.

You should be aware that after this period ends, your rates and payment could change significantly – even if the industry interest rates are stable.

Adjustment period

This is the point at which the interest rate on an ARM will likely change and where you could potentially begin to face higher monthly payments.

Interest rate caps and floors

It’s important to consider all angles of an ARM, including how low or high your interest rate can actually go during the life of the loan. You’ll want to have your lender calculate the highest monthly payment that you may be required to pay, to determine if you’re comfortable with that amount. You will also want to know how low your interest rate can go; sometimes, even if the industry rates decrease dramatically, your rate might not be able to fall that low. Both are things you’ll want to consider if you plan to hold the loan for a length of time longer than the initial rate period.

Benefits of an adjustable-rate mortgage

Like most things in life, there are pros and cons to every situation – and the type of mortgage you choose is no different. When it comes to an ARM, there are certainly benefits to going that route – as you’ll see below.

Lower initial monthly payments

Since the initial rate of an ARM is often lower than a fixed-rate mortgage, you can benefit from lower monthly payments for the first 3, 5, 7 or 10 years, for example – depending on your particular mortgage situation.

Short-term home

Perhaps you are in the military and will be moving within a specific number of years, or maybe you know your career is going to take you somewhere new within 5 or so years. If this sounds like you, choosing an adjustable-rate mortgage may be a good option since you’ll likely pay less during this time period than you would with a fixed-rate mortgage.

Another way to consider the timing is to think about your proposed loan’s initial rate period. Let’s suggest the initial rate period is five years. If you’re planning to stay in the home less time than that, or close to that amount of time, an ARM may be an option to consider.

Accepting risk for reward

Yes, it’s true – taking out an adjustable-rate mortgage is kind of like gambling in a sense. You could end up saving quite a bit of money over the life of the loan if mortgage rates decline in the future, lowering your monthly payment. However, even with serious forecasting abilities, knowing for certain the risk will pay off is nearly impossible. The most important thing to note is, you’ll want to ensure you can afford the potential of higher monthly payments if interest rates rise.

Why an arm may not be for you

While there are certainly compelling reasons why you’d want to consider an adjustable-rate mortgage, there are also reasons why it may not be your best option.

Higher monthly payments

Yes, one of the benefits of an ARM was lower monthly payments – but it also has the potential to bring higher monthly payments after the initial rate period. For many Americans, not knowing how much their revolving debt will be month-to-month can be a quite uncomfortable feeling.

In any case, knowing upfront how high your monthly payment could go with an ARM can give you peace of mind before making the choice.

You've found your forever home

You may think the term ‘forever home’ is one used primarily by those with children who are grown and have moved out of the family home – however, that’s simply not true any longer. In fact, 75% of first-time buyers intend to skip the starter home in favor of a home that they will live in for the long haul (i.e., through adopting pets, having children, and even gaining grandchildren, etc.). If you’re looking for your forever home, the major perk of an ARM (lower initial rate period) may not appeal to you, since you may live there for the duration of the loan term.

You don't enjoy risk

Feeling secure is something many of us appreciate. So if you don’t like the thought of taking risks, that’s entirely understandable! Fortunately, your mortgage is something you don’t have to take a risk on – you have the option to go with a fixed-rate mortgage instead of an ARM, which can provide peace of mind, since you’ll know exactly what your monthly payment will be for the life of the loan.

When it comes to applying for a mortgage, it’s important to carefully consider your options to ensure you make the best decision for your financial situation. Don’t forget to enlist the help of a mortgage banker to guide you through the decision-making process!