When to consider an Adjustable Rate Mortgage (ARM)4 Minutes
There are many different types of mortgage products available to meet the needs of anyone buying or refinancing a home.
There is one in particular that is surrounded by misinformation, and a lot of confusion: the Adjustable Rate Mortgage or ARM.
ARMs haven’t been very popular in recent years mostly because they were the mortgage product of choice used by unscrupulous lenders that contributed to the housing market crash in 2008. Today, merely suggesting this product as a viable mortgage option makes lenders feel like the villain.
However, there are certain scenarios where the ARM may be a good option to consider.
This article explores some potential reasons for considering an ARM in addition to the traditional fixed-rate mortgage options. Before you continue, please be sure you’re familiar with how an ARM loan works and understand the key terminology that goes along with an ARM loan. With that as your foundation, here are some of the key reasons you may want to consider an ARM for yourself.
Reason #1: Lower Initial Interest Rate
Most ARMs feature a lower initial interest rate compared to a traditional 30-year fixed-rate mortgage. This means your monthly principal and interest payment will also be lower during the initial term of your ARM loan. The key words here are initial interest rate. While the rate does not change during the initial fixed rate period, it will change after that, making this a limited time benefit.
Reason #2: Short-Term Ownership
If you expect to live in the home you’re purchasing for less than five years, a 30-year fixed-rate mortgage is likely more expensive than some ARM options. If you select an ARM program with an initial fixed period that matches or exceeds your expected ownership timeline, you’ll benefit from the lower rate compared to the traditional 30-year fixed-rate, and can avoid having to pay a higher rate down the road if you refinance or sell the home before the end of the initial fixed rate period.
Reason #3: Less Interest For Larger Loan Amounts
Monthly interest payments are calculated on the unpaid loan balance. Larger loans therefore accrue more annual interest than smaller loans. ARM’s that have a lower initial rate period compared to fixed-rate mortgages can save homeowners by providing them with years of lower interest payments for higher priced homes.
For example, a $100,000 loan at 5.25% will cost about $5,250 in annual interest while a $400,000 loan at the same rate will cost around $21,000 in annual interest. If the homeowner instead opted for an ARM where the initial rate dropped to 4%, they would save $1,250 in annual interest on the smaller loan amount and about $5,000 on the larger one. Over the span of five years that equates to $6,000 or $25,000, respectively. Paying the closing costs (typically 1-3% of the loan amount) before the rate adjustment period could easily be justified given those savings.
Reason #4: Longer Repayment Period
Most ARMs feature a 30-year repayment period (term) just like a traditional 30-year fixed-rate mortgage. Some lenders have recently begun offering programs that increase that term to 40 years for certain ARM products. A longer repayment period can make monthly payments more manageable, and can also help when it comes to getting approved for a loan.
Reason #5: You Expect Rates to Decrease Over Time
If you expect rates will decline over the next several years compared to where they are today, then it may be worth considering an ARM. You can take advantage of the lower interest rate now, and refinance into a low fixed rate when they go down a few years later.
The bottom line is that ARMs do offer some key advantages in certain situations, but they also come with added risks you must understand on the front-end.
Be sure to work with an experienced and knowledgeable lender who will take the time to explain the pros and cons to you. Too many lenders and individual lending officers push the benefits of lower initial payments without sufficiently educating borrowers on the associated risks.
Working with a credit union can help diminish this risk since credit unions are nonprofit entities that place the highest priority on serving members rather than maximizing profits.