Are adjustable-rate mortgages bad?

Here is how you can decide whether ARMs are a good idea for you

Are adjustable-rate mortgages bad?

Whether an adjustable-rate mortgage, or ARM, is a good option for you depends entirely on your individual circumstances. What is crucial when weighing up the choice is that you know what you are getting yourself into. Because ARMs can be complex, here is everything you should know.

What is an adjustable-rate mortgage?

An adjustable-rate mortgage, also called an ARM, is a mortgage with a variable interest rate. The initial interest rate for an adjustable-rate mortgage is fixed for a certain term. Following that term, the interest rate that is applied to your outstanding balance starts over at monthly or yearly intervals, which can rise or fall. Adjustable-rate mortgages, which are also called variable-rate mortgages or floating mortgages, also have interest rates that are reset according to an index or a benchmark, with an additional spread that is dubbed the adjustable-rate mortgage margin.

While interest rates are unpredictable, over the last 10 years or so they have tended to go both up and down in cycles. And interest rates, though expected to rise over the current year, are still relatively low when viewed historically. In other words—fixed-rate mortgages are a good option right now. An adjustable-rate mortgage is a good option for you if you do not hope to stay in the property over a longer term, or in a high-rate environment.

How does an adjustable-rate mortgage work?

The 5/1 adjustable-rate mortgage is the most popular ARM. The ‘5’ in the 5/1 ARM means that the introductory rate lasts for five years. Following that period, the interest rate can change each year, which is where the ‘1’ comes into the 5/1 equation. Lenders may also offer 10/1 ARMs, 7/1 ARMs, and 3/1 ARMs. Since adjustable-rate mortgages are capped by a limited amount by which payments and rates can change, you are insulated from potentially costly year-to-year spikes in monthly payments.

Examples of the caps include:

  • A life-time rate cap limiting the amount the interest rate can rise over the life of the loan
  • A periodic rate cap limiting how much the interest rate may change from year to year
  • A payment cap limiting the amount the monthly payment can increase over the life of the loan in terms of money, instead of how much the rate might change in percentage.

What are the dangers of an adjustable-rate mortgage?

The dangers of an adjustable-rate mortgage include the following:

Your payments may increase. Your payments might rise after the adjustable period starts if interest rates are on the rise. You could potentially run into issues making the bigger payments.

Things do not go as you planned. Adjustable-rate mortgages require that you plan for the time when interest rates begin changing and monthly payments start to increase. Despite careful planning, you could still not be able to refinance or sell when you want. This means that you could lose your property if you are unable to make the payments following the fixed-rate phase of your loan.

Pre-payment penalty. Occasionally, adjustable-rate mortgages come with a pre-payment penalty attached. The pre-payment penalty is a fee that you may be charged for refinancing or selling the home. If you have plans to sell or refinance before the first five years of your mortgage, you should look for lenders that offer mortgage loans without this pre-payment penalty.

Adjustable-rate mortgages can be complicated. Adjustable-rate mortgages often have complex rules, structures, and fees. If you do not totally understand what you are getting yourself into, these complexities are likely to pose risks to you.

Is an ARM a good idea?

The short answer to this question is that it depends on a few factors. An adjustable-rate mortgage could potentially be a sound financial option if you are hoping to keep the loan for a limited period and whether you are capable of handling potential rate increases in the meantime.

Adjustable-rate mortgages, in any case, come with rate caps that place a limit on how much the rate can increase in total or at any given moment. For instance, life-time rate caps limit how much the interest rate can rise over the lifetime of the loan. Periodic rate caps, on the other hand, set limits on how much the rate can change from one year to another. There are adjustable-rate mortgages that also cap how much the monthly mortgage payment can rise in terms of dollars.