Pros and Cons of Adjustable-Rate Mortgages
When mortgage rates go up, homebuyers start hearing about adjustable-rate mortgages, also known as ARMs.
ARMs can save new homeowners serious money in the first few years of homeownership, just when they need room in their budget.
But are ARMs a good idea? For many, yes; for others, no way. Here are the biggest pros and cons of adjustable-rate mortgages.
More: Looking to buy soon? Set yourself up for having your offer accepted on a home by getting preapproved for a mortgage prior to your home search.
Adjustable-rate Mortgage Pros
The barrage of costs that face homebuyers – repairs, new furniture, longer commutes – is hard to handle for those with sky-high mortgage payments.
But there’s a potential remedy.
ARMs Make Homeownership More Affordable
According to Freddie Mac, the average five-year ARM rate was 1.01% lower than the 30-year fixed rate mortgage at the end of July 2022. That’s a hefty discount.
The difference in rate would save a homebuyer $183 per month on a $300,000 mortgage, or nearly $11,000 over five years.
Homeowners who are already feeling the squeeze of higher rates could potentially relieve some pressure by choosing an adjustable-rate mortgage.
Most ARMs come with an initial fixed period of three to 10 years. The most popular ARM is called a 5/1: For five years, the rate is fixed, and then adjusts annually.
Learn More: Calculate your ARM payment with a trusted lender
There Are Caps on the Adjustments
Today's ARMs come with “caps” on how high and how fast the rate can rise after the initial fixed period. Fannie Mae and Freddie Mac, agencies whose rules most lenders follow, state that ARM loans can rise just 2% at the first adjustment and 1% every six months thereafter on three- and five-year ARMs.
Furthermore, ARM loans can rise only 5% higher than the initial rate, ever.
For instance, such an ARM with a 4.5% introductory rate can’t rise past 6.5% at the first adjustment and higher than 9.5% ever.
The highest possible rate is no bargain, but most ARM consumers can’t end up with a 25% mortgage rate as they might fear.
ARMs got a bad reputation after the subprime mortgage bust sparked a financial crisis in 2008. But, the toxic mortgages that were available back then, such as so-called “exploding ARMs” that allowed rates to triple in the first adjustment, are no longer allowed.
Your ARM Payment Can Fall, No Refinance Required
Yes, an ARM rate can rise after the initial fixed period, but it can also fall.
With a fixed-rate mortgage, you have to refinance to get access to lower rates, incurring thousands of dollars in fees.
But with an ARM, your rate could follow the market once the loan is in the adjustable period.
An adjusting ARM is based on an index plus the margin. The index is a floating measure of current market rates and the margin is the lender’s profit above that. The margin never changes.
Here’s how it could work:
Initial fixed rate for five years: 4.5%
Index falls to 1.5% in year six
Rate at first adjustment: 4.25% (1.5% index + 2.75% margin)
Most ARMs today are based on the Secured Overnight Financing Rate (SOFR) which currently sits at about 2.30%. But it was around 1.5% just a few months ago.
If you get a five-year ARM loan today, and rates are lower in six years, there’s a good chance you’ll pay less each month when the rate starts to adjust.
ARMs Are Fantastic If Your Situation Is About to Change
Those who are just starting out in their careers will experience higher incomes and lower debt payments as time goes on. An ARM loan can help them break into homeownership sooner.
Future payment increases, if they come, will be handily conquered with higher incomes.
ARMs can also work for single-income families that plan to have dual income in a few years.
Adjustable-rate loans also pay dividends for those planning to sell, refinance, or pay off the home in a few years.
Adjustable-rate Mortgage Cons
Your Payment Could Rise
No surprise here: your rate and payment could rise if you have the ARM longer than the initial fixed period, typically three, five, or seven years.
It sounds scary to new homebuyers: you wake up one day and your payment is higher!
As described earlier, built-in protections temper your rate increase to just 1% to 2% at a time. For instance, if your rate goes from 4.5% to 5.5% on a $300,000 loan balance, you would pay an extra $180 per month.
While not pleasant, that amount does not mean eternal doom and destruction for most families.
Calculate your worst-case scenario after your fixed period and make sure you’ll be able to afford it by then.
You Might Not Be Able to Refinance Out of an ARM
Not everyone will be able to refinance out of an ARM when they need to. Here are a few possible things that could happen as you approach the end of the initial fixed period.
You lose your job.
Your credit score drops.
Your home value sinks.
You could be stuck with your ARM longer than you planned.
You Might Lose Sleep at Night
Let’s face it: some of us worry too much.
If that’s you, perhaps an ARM loan isn’t the right call. Some are comfortable with risk, others are not.
If you are the type to pace the halls all night worried that, one day, your payment will skyrocket, by all means, get a fixed rate loan.
Should You Get an ARM?
Sit down and have a good think about whether an ARM is right for you. Your risk tolerance, future financial situation, and current budget all play into the decision.
A mistake, though, is instantly dismissing ARM loans. With higher home prices and rates in the post-pandemic world, an ARM could mean the difference between owning a home or renting for many more years.
Don't Miss: Thinking about buying a home but want to secure a good rate? Use this tool to find a lender that gives you the power to lock an interest rate for an extended period so you can shop around for a home comfortably knowing that your rate is secure and won't go up.
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Tim Lucas spent 11 years in the mortgage industry and now leverages that real-world knowledge to give consumers reliable, actionable advice. Tim has been featured in national publications such as Time, U.S. News, MSN, The Mortgage Reports, My Mortgage Insider, and more.