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Adjustable-Rate Mortgage Pros and Cons

Taking a mortgage is something you need to do on an informed basis. Even though this process may seem complicated, with the proper information, you will be able to make the best call for yourself.

So if you are thinking about taking an ARM, first find out what are adjustable-rate mortgage pros and cons.

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.

Couple holding a home sign

In the end, the decision to take this type of credit depends on your preference and current financial situation. If you weigh the pros and cons carefully and find a good advisor to guide you, the risks shouldn’t be that big. Still, it is up to you to decide what kind of arrangement works best.

What Is ARM and How Does It Work?

An adjustable-rate mortgage or ARM is a home loan with an interest fee that can change periodically. The interest rates on such mortgages will follow and adjust to the interest amount in the marketplace. That means your monthly payment can either increase or decrease. When you apply for a mortgage, you will get an initial fee that’s fixed for a period of time with ARM. After this period expires, your mortgage lender will adjust your fee to the market.

How Does an ARM Loan Work?

As we mentioned, once you finish your application process, you will be offered an initial interest fee that is typically lower than the fixed one. But how much your monthly payment increases or decreases will depend on your credit structure and type. In essence, most ARMs consist of the following features:

  • Initial fee and payment – This is the fee you will get once you are approved for a mortgage, and your lender calculates all the expenses you will have, such as mortgage insurance, lenders fees, closing costs, and, of course, escrow property tax. Once you combine these expenses with an interest fee, you will get your monthly payments. You will pay a fixed amount for a certain period, usually between one month and ten years.
  • Adjustment period – This is the amount of time you will have between changes to the installments. Most of them are changed annually, monthly, quarterly, or every three to five years.
  • Index – This is a measure your lender will use to calculate the interest fee. If the index goes up, so will your monthly payment. 
  • Margin – This is an extra amount of percentage points your lender will add to the index when calculating your full index fee. 

You will get your full index fee once you add an index to the margin. For example, if your lender currently uses a 3% index and margin of 3%, your full index will be 6% (3% +3%). So if the index goes from 3% to 6%, your full index will be 9%. Or if it goes down from 3% to 2%, it will be 5%. All margins will vary from lender to lender, and not all of them will go down, so before you sign any contract, make sure you learn all about your credit and how you can lower payments. Check this video for more information about ARMs and how they work.

https://www.youtube.com/watch?v=S-mTwg73jCY&ab_channel=KhanAcademy

Types of ARMs

When it comes to ARM loans, most of them are hybrid ones, and they combine features of fixed and adjustable rates. They are usually marked with two digits, like 3/1. The first digit indicates the length of the fixed period, and the second digit indicates how often the fee will adjust afterward. So if you get a contract with 3/1 numbers on it, it means your fixed period will be three years and that your fee will adjust annually. But there are different kinds of adjustable loans, and each of them is structured differently. Here is how they look:

NameInitial PaymentsAdjustment
HybridFee is fixed for a specific amount of time.After the initial fixed period is over, the fee will adjust until the debt is paid off.
Interest-onlyYou can pay only an interest fee for an arranged amount of time.Once the interest-only period is over, you will pay both principal and interest fees until you pay off your debt.
Payment optionYou can choose between three options every month.You can make traditional principal and interest payments, interest-only payments, or a limited payment.

Fixed Mortgages vs. ARMs

A fixed-rate mortgage (FRM) is a loan where your interest fee will be settled from the beginning till the end of your loan. The FRM is a safer option because your interest will not change – the only thing that will change is your taxes. The ARMs are riskier, but you will pay less in the beginning. Both types have their advantages and disadvantages. For example, FMR usually has higher rates, but the loans last longer, so you can spread out your payments to 30 years.

Pros and Cons of FRM

Even though most people choose FRM, there are still some things you need to consider when applying for mortgages. For example, if you wish to pay off the mortgage faster, maybe the better option will be to take some FRM loans because, for example, there are no penalties if you decide to pay off a 30 years loan in 15 years. Make sure you talk to your mortgage broker about all the options and choose the one that suits your financial situation best.

FRM ProsFRM cons
The rates will be the sameHigher interest rates
You can plan your budget much easierMonthly payments will be higher
There are no prepayment penaltiesHarder to qualify
Excellent for long term homeownersNot so good for short term homeowners.

Adjustable-Rate Mortgages Pros and Cons – Benefits

Still, many people decide to take ARM, and there are many benefits to doing so. For example, you will qualify for a mortgage much faster. Also, you will initially have fewer payments, so if you still don’t know how much debt you can afford, maybe ARMs are best for you.

Lower Initial Monthly Payment

With a lower interest fee in the initial period before the adjustment, your payments will be lower than with FRM. That leaves you a window where you can save some money. For example, if your current financial situation doesn’t allow you to pay big amounts of money each month, then ARM is excellent to start with, but only if you know that, in the future, your income will be higher.

You Can Get a Larger Mortgages and Your Dream House

Another benefit of ARMs is that, typically, lenders will give you larger amounts of money. A lower fee allows borrowers to lend the highest amount possible. For example, if you get a 5% reduction in the interest fee, this can save you thousands of dollars, compared with FRM, which allows many borrowers to buy bigger and nicer homes.

Couple looking at their dream house

Good for People Who Wish to Buy a Home for Shorter Periods of Time

If you are buying a home you know you will sell in five to ten years, you don’t have to worry about how to pay off your deed in five years. For example, you can take 5/1 ARM,  pay only the initial period, and sell the home once the adjustable period arrives. This way, you will save a lot of money and skip the risky part of ARM.

Your Payments May Go Down

Last but not least, don’t forget that your payments may go down after the initial period. If the index fee goes up, so will your monthly payment, but if it goes down, your fee will go too. And even though it is hard to predict how much you will have to pay in the end, it is a calculated risk you will take. And if it goes down, you will save tons of money.

Calculator and cash

The Disadvantages of an ARM

The main downside of an ARMs is that, after the settled period is over, you can never be certain how much you will pay. That can be stressful, especially if you earn just enough money to pay your bills. With ARMs, there will not be fixed expenses, and if your index goes higher, you can land in a really bad financial situation. Also, even though most ARMs are adjusted annually or quarterly, don’t be surprised if you see an increase in your monthly payments. These spikes can sometimes end up being double the amount you paid until the adjustment.

Another disadvantage of ARM is that, if your house price changes over the years and you wish to refinance after five years, this will be difficult. Refinancing home from an ARM to FRM will be hard and can put you at a disadvantage in the end.

Man shaking hands with broker

Which Loan Is Right for You?

Before you make up your mind and sign any loan agreement, you should first consider what kind of credit is best for you. If you consider taking ARM, ask yourself the following questions:

  • Can I afford an increment?

Calculate the worst-case scenario and see if you can cover that with your current income.

  • Will my income increase or decrease?

For people who have a stable income that they know will not increase drastically over the next couple of years, FRM will make more sense. But if you know you will have a bigger salary in the next couple of years, then you will be able to pay off any installments.

  • Can I pay off the credit before the adjustment?

The ARM can be a truly attractive credit for people who have a big cash flow or plan to have one in the near future. For example, if you are thinking of investing in real estate, you can buy one property and sell another. This way, you will have enough cash to pay off your loan quickly. Also, if you know that you have enough money to pay off the debt before the adjustment, you will save a lot of money.

Man calculating monthly payments

Make Your Choice Carefully

The bottom line is that both types have their pros and cons, and you will choose between them depending on your financial situation. In the end, ARM will cost you less at the beginning, but if you don’t have a high income, it will be riskier for you. On the other hand, if you have cash flow and income that can cover any drastic increases, the ARM is an excellent choice for you. Before you sign any contract, make sure you read all the fine print and go with a lender that offers as few changes as possible. This way, you will decrease the risks in the long run.

Also, if you plan to refinance your home before the initial period is over, this loan is excellent for you. Just keep in mind that these loans come with some prepay penalties, so make sure you know when these penalties will be enforced and how much you will have to pay. So, in the end, if you wish ARM to work for you, make sure you have a good advisor at your side and to calculate all possible outcomes carefully.