Follow this series to learn how to get the best mortgage for your specific financial situation and goals. You’ll see what steps you need to take throughout this process to make it productive and successful.
This week, you’ll learn about another loan option – adjustable rate mortgages or ARMs. You might be surprised that ARMS could be a good fit for you after all.
Most buyers have heard scary stories about ARMs -- adjustable rate mortgages -- from family members or from headlines years ago. It seemed like homeowners would face crazy increases and end up getting in over their heads.
Today’s ARMs are not that way at all. Gone are the risky features such as interest-only and balloon payments. (Yep, those do sound risky!)
In fact, an ARM could be a cheaper and more affordable alternative for you than a fixed-rate mortgage. This can be true for many first-time buyers who don’t plan to stay longer than 7 years in their next home.
However, you should always tread carefully and fully understand ARMs. That’s why you’ll get a rundown on how they work and what you need to look out for if it’s an option you are considering.
Remember, not every loan is right for every person and it depends on your particular financial situation, goals, and home buying plans (not your neighbor’s, your mom’s, or your co-worker’s). I am always here to go over what is best for you.
What is an ARM and how does it work?
For a certain time period, an ARM acts just like your standard 30-year fixed mortgage since payments are the same and interest rate doesn’t change. This initial fixed-rate period can be for 1 year to 3, 5, 7, or 10 years — you get to choose the timeframe. The current standard is 5 years or a 5/1 hybrid ARM.
ARMs differ from fixed-rate mortgages in that the interest rate and monthly payment do not stay “fixed” for the length of the mortgage but fluctuate or “adjust” at some point during the life of the mortgage.
After this fixed-rate period, the rate is adjusted each year and the new payment is based on market indexes. The new rate and payment are calculated by determining what the index value is and then adding a margin to that figure.
How are they less risky?
Buyers no longer need to be as wary when the rate starts to adjust. Lenders protect borrowers from extreme rate changes with payment cap limits, either with an annual cap or life-of-the-loan cap.
That means that you will know upfront what interest rate your loan could never exceed and how often it could change and by how much. You need to make sure you read your closing documents for all of the specifics.
Why are they a good alternative for some buyers?
Simply put, an ARR can be cheaper and more affordable. Even though fixed-rate mortgages are historically low (they track 10-year Treasuries), they are higher than ARMs. The Federal Reserve is keeping short-term rates low and ARMs track those rates (1-year Treasuries).
An ARM may be your ticket to homeownership if a fixed-rate is derailing you.
Is an ARM right for you?
An ARM is good for buyers who have a plan for the next 5 or 7 years and will more likely move before the loan’s fixed-rate period ends. A 30-year fixed-rate loan may not work as well for those buyers who don’t want to stay put in one home for a long time.
For example, if you live in a small condo but your family is growing, an ARM will help you move to a larger home. You will be able to take advantage of lower monthly payments for several years with the ARM instead of renting.
If you’re in a highly transient profession, like the military, and expect to relocate or transfer, the ARM is a short-term product that could fit into your plans.
Here’s how it would work:
If you plan to stay in your home for only 5 years, you really won’t be able to take advantage of the guaranteed rate of a fixed long-term loan. Instead, you can choose a 5/1 hybrid ARM — one that is fixed for 5 years and then adjusts upward.
You will shave several percentage points off of the fixed 30-year rate, and as the 5 year adjustment draws closer, you already know that you will be moving on, and likely selling.
Can homeowners trade in a fixed loan for an ARM?
Yes, you can trade your current loan for an ARM. You’ll lower both your interest rate and your payments over the short term. If you’re a savvy homeowner, you can pay down your mortgage with the money you saved by getting an ARM. Your loan will be much more manageable and you will also be able to cope with any rate changes.
Who should avoid an ARM?
ARMS are not for everybody, especially if you’re not a confident borrower.
If you’re uncertain about your income rising right along with housing prices when your ARM adjusts, you may be more comfortable with a fixed-rate loan.
If you plan to stay in your home for the long term, say 15-20 years, it just doesn’t make sense to pay a higher mortgage bill after 5 or 7 years.
Top 4 Questions to Ask
Do I have enough income to cover higher mortgage payments if interest rates go up?
Am I taking on other sizable debts (a loan for a car or school tuition) soon?
How long do I plan to own this home? (If you plan to sell soon, rising interest rates may not pose a problem)
Will I make any additional payments or pay the loan off early?
ARMs aren’t for everyone. But if you aren’t planning on owning your home for long, then it’s a loan that might be worth looking into and could even save you money.