Adjustable Rate Mortgage: Pros, Cons and Considerations

An adjustable-rate mortgage (ARM) is a type of home loan with an interest rate that can change over time, based on changes to a benchmark index rate. The initial interest rate is typically lower than a fixed-rate mortgage, but it could increase or decrease over the life of the loan as market rates change.

With an ARM, the interest rate is fixed for an initial period, after which it periodically adjusts up or down. Common initial fixed periods are 3, 5, 7 or 10 years. The frequency of adjustments is also set in the mortgage terms, usually annually but sometimes as often as monthly.

The main difference between adjustable-rate mortgages and fixed rate mortgages is that, with adjustable-rate mortgages, the interest rate may change periodically. This can cause your monthly payments to increase or decrease. With a fixed rate mortgage, your interest rate will remain the same for the life of the loan.

How Does an Adjustable Rate Mortgage Work?

The interest rate on an ARM has two components – the index and the margin. 

The index is a benchmark interest rate that the ARM is tied to. Common indexes include the U.S. Prime Rate, London Interbank Offered Rate (LIBOR), 11th District Cost of Funds Index (COFI), and U.S. Treasury securities.

The lender sets a margin or spread over the index. For example, if the index is 5% and margin is 2.5%, the ARM rate would be 7.5%. 

The rate adjustment caps limit how much the interest rate can change at each adjustment and over the life of the loan. There are often periodic and lifetime caps.

Pros of an Adjustable Rate Mortgage

1. Lower Initial Interest Rates

ARMs often start with a teaser rate below current fixed rates. This makes the initial monthly payments lower, helping borrowers qualify for a larger loan amount. It provides payment relief especially when interest rates are high or you have an irregular income.

2. Potential for Lower Total Interest Cost

If interest rates decrease, ARMs could have a lower rate over the life of the loan compared to a fixed rate. This depends on how much rates rise or fall in the future, which is unpredictable.

3. Flexibility for Short-Term Homeownership

If you plan to sell your home within a few years, an ARM with a low initial rate can minimize total interest costs during your ownership period. You won’t be locked into higher fixed rates designed for long-term financing.

Cons of an Adjustable Rate Mortgage

1. Uncertainty and Risk of Rising Rates

After the initial period, the interest rate and monthly payment can increase significantly. It makes financial planning difficult and could stretch your budget in the future.

2. Complex Terms and Conditions

ARMs come with more complex specifics like the index, margin, caps, and adjustment schedule. It’s important to understand the details to avoid surprises.

3. Potential for Negative Amortization

If an ARM offers payment caps but no rate caps, the interest owed could exceed your payment. This builds a balance owed that increases the loan amount and future interest – also known as negative amortization.

Here is a table summarizing the key pros and cons of adjustable-rate mortgages:

Who Should Consider an Adjustable Rate Mortgage?

Adjustable-rate mortgages can be a good option for certain borrowers, depending on their financial situation and outlook. Specifically, ARMs may make the most sense for homeowners who are only planning to keep the mortgage for a few years. Because ARMs often start with lower teaser rates, they minimize total interest costs during a short ownership period. Homeowners who expect to move or refinance before the initial fixed-rate period ends can benefit from lower payments in the near-term without getting locked into a higher fixed rate.

Borrowers who can comfortably handle potential payment increases may also be good candidates for ARMs. If you have a stable income, low debt-to-income ratio, substantial savings and investments, and a high credit score, you may be able to absorb a future rate increase more easily. Individuals who expect their incomes to rise significantly in the coming years are often able to absorb higher adjustable mortgage payments over time.

For homebuyers who anticipate interest rates will decline during the mortgage term, an ARM could provide an advantage. If rates go down, they can lock in a lower rate when the ARM adjusts. This scenario would provide lower rates than a fixed-rate mortgage over the full loan term. On the other hand, borrowers who expect rates to rise substantially may want to opt for a fixed-rate mortgage to lock in lower rates now.

In general, adjustable-rate mortgages make sense for borrowers who are more concerned about lower initial costs than lifetime interest expenses, and for those comfortable accepting some risk and uncertainty in exchange for potential savings. Consulting with a loan officer can help determine if an ARM aligns with your individual home financing needs and risk tolerance.

What Are the Alternatives to an Adjustable Rate Mortgage?

Common alternatives include:

• Fixed-rate mortgage – The interest rate remains unchanged for the full loan term, typically 15 or 30 years. This provides predictable payments.
• Interest-only mortgage – You pay only interest for a set period, with payments recalculated later to pay down principal. This lowers initial costs but increases long-term totals. 
• Balloon mortgage – After fixed payments based on a long amortization schedule, the balance must be paid at maturity in a balloon payment. This also defers costs.

How to Decide If an Adjustable Rate Mortgage Is Right for You?

Determining if an adjustable-rate mortgage is the right fit requires carefully evaluating your personal financial situation, risk tolerance, and future plans. Start by analyzing your budget to see if you can comfortably handle potential payment increases. Factor in your total income, expenses, existing debts, and savings to assess your ability to absorb a rate hike.

Also think about how long you realistically plan to stay in the home. If you may move in a few years, an ARM with a low initial teaser rate can save on total interest costs during your ownership period. On the other hand, a fixed-rate mortgage provides long-term stability and predictability if you plan to keep the home long-term.

You’ll also want to research economic projections on interest rate trends and discuss forecasts with loan officers. If rates are expected to fall, an ARM could provide savings, while fixed rates are better if hikes are projected.

Compare current rate differences between ARM and fixed-rate loan options and calculate the long-term costs in different interest rate scenarios. Weigh the risks and potential rewards to determine your comfort level. Meeting with a loan officer to discuss your unique situation and risk tolerance can provide key considerations before deciding on the best mortgage structure for your needs.

What Factors Should You Consider When Choosing Between a Fixed-Rate and an Adjustable-Rate Mortgage?

Some key considerations include:

• Interest rate trends – do you expect rates to rise or fall? 
• Loan term – how long do you plan to keep the mortgage?
• Home budget – can you afford potential payment increases?
• Future plans – are changes expected in income, expenses, or residence? 
• Loan costs – what are the upfront fees and rate caps for each option?
• Tax implications – will rate changes affect deductions?
• Personal risk tolerance – are you comfortable with or adverse to uncertainty?

Analyzing both types of mortgages in light of your unique financial situation and risk preferences can help determine if an adjustable-rate mortgage is the right choice. Consulting mortgage calculators and a loan officer provides further insight into the pros and cons. Carefully evaluating the long-term costs and risks allows you to make an informed mortgage decision.

Frequently Asked Questions(FAQ)