The interest rate on your loans determines how expensive it is to borrow money. The higher the interest rate, the more expensive the loan.
With a conventional, 30-year fixed-rate mortgage, borrowers with the best credit can expect to receive a 4.23% interest rate on that loan. The average homebuyer borrows about $222,000 when they take out a mortgage, which means paying a staggering $168,690 in interest over the term of the loan.
When you need to repay balances in the hundreds of thousands of dollars, even half a point of interest can make a huge difference in how expensive your mortgage is. If you borrowed the same amount but had a rate of 4.73% rate, you’d pay $192,190 in interest — or almost $24,000 more for the same loan.
Given that interest rates make such a big impact on how much your mortgage costs, it makes sense to do what you can to get the lowest rate possible. And this is where adjustable-rate mortgages can start to look appealing. In two cases especially, it makes perfect sense to go with an ARM: when you plan to pay off your mortgage quickly, or you plan to move out of the home within a few years.
Adjustable-Rate Mortgages Can Allow You to Borrow at Lower Rates
An adjustable-rate mortgage, also known as an ARM, is a home loan with a variable interest rate. That means the rate will change over the life of the loan.
ARMs are usually set up as 3/1, 5/1, 7/1, or 10/1. The first number indicates the length of the fixed rate period. If you look at a 3/1 ARM, the initial fixed rate period lasts 3 years. The second shows how often the interest rate will adjust after the initial period.
Some ARMs come with interest rate caps, meaning there’s a limit to how high the rate can adjust. And their initial rate is often much lower than traditional fixed-rate loans.
This can help you buy a home and start paying your mortgage at a lower monthly cost than you could manage with a fixed-rate mortgage. Borrowers with the best credit scores can access a 5/1 ARM with an interest rate of 3.24% right now.
The Risks ARMs Pose to Average Homebuyers
“The main advantage of an ARM is the low, initial interest rate,” explains Meg Bartelt, CFP, MSFP, and founder of Flow Financial Planning. “But the primary risk is that the interest rate can rise to an unknown amount after the initial, fixed period of just a few years expires.”
Homebuyers can enjoy extremely low interest rates for a month, a quarter, or 1, 5, 7, or 10 years, depending on the term of their adjustable-rate mortgage. But borrowers have no control over the interest rate after that.
The rate can rise to levels that make your mortgage unaffordable. Remember our earlier example, where just half a point of interest could mean making the entire mortgage $24,000 more expensive?
ARMs adjust their rates periodically, and the new rate is partly determined by a broad measure of interest rates known as an index. When the index rises, so does your own interest rate — and your monthly mortgage payment goes up with it.
The variable nature of the interest rate makes it difficult to plan ahead as your mortgage payment won’t be static or stable.
“Imagine at the end of year 5, rates start going up and your mortgage payment is suddenly much higher than it used to be,” says Mark Struthers, a CFA and CFP who runs Sona Financial. “What if your partner loses their job and you need both incomes to pay the mortgage?” he asks. In this situation, you could be stuck if you don’t have the credit score to refinance and get away from the higher rate, or the cash flow to handle the extra cost.
“Once you get in this spiral, it is tough to get out,” says Struthers. “The spiral just gets tighter.”
And yes, adjustable-rate mortgages can go down. While that’s possible, it’s more likely that the rate will rise. And some ARMs will limit how high and how low your rate can go.
Struthers puts it plainly: “ARMs are higher-risk loans. If you can handle the risk, you can benefit. If you can’t, it can crush you. Most people do not put themselves in a position to handle the risk.”
Who Can Make an ARM Work in Their Favor?
That doesn’t mean no one can benefit from adjustable-rate mortgages. They do come with the benefit of the lower initial interest rate. “If you plan to pay off the mortgage during that initial fixed period, you eliminate the risk [of getting stuck with a rising interest rate],” says Bartelt.
That’s exactly what she and her husband did when they bought their own home.
“In my situation, we had enough savings to buy our house with cash. But the cash was largely in investments, and selling all the investments would push our income into significantly higher tax brackets due to the gains, with all the cascading unpleasant tax effects,” Bartelt explains.
“By taking an ARM, we can spread the sale of those investments out over 5 years, minimizing the income increase in each year. That keeps our tax bracket lower,” she says. “We avoided increasing our marginal tax rate by double digits in the year of the purchase of our home.”
She notes that another benefit of taking the ARM in her situation was the fact that she and her husband could continue to pay the mortgage past that initial 5 years if they chose to do so. “The interest rate won’t be as favorable as if we’d initially locked in a fixed rate,” she admits. “But that option still exists, and having options is power.”
Planning for a Quick Sale? An ARM Might Work for You
Another way ARMs can provide benefits to homeowners? If you won’t live in the home for long. Buying the home and also selling it before the initial rate period expires could provide you with a way to access the lowest possible rate without having to deal with the eventual rise in mortgage payment when the rate increases.
“ARMs are typically best for those who are fairly certain they won’t be in the house for a long period of time,” says Cary Cates, CFP and founder of Cates Tax Advisory. “An example would be a person who has to move every two to four years for their job.”
He says you could view taking out an ARM as a way to pay “tax-deductible rent” if you already know you don’t want to stay in the house for more than a few years. “This is an aggressive strategy,” he explains, “but as long as the house appreciates enough in value to cover the initial costs of buying, then you could walk away only paying tax-deductible interest, which I am comparing to rent in this situation.”
Cates says you’re obviously not actually paying rent, but you can mentally frame your mortgage payment that way. But you need to know the risk is owing on your mortgage if you go to sell and the home hasn’t realized enough appreciation to cover what you spent to buy.
He also reminds potential homebuyers that you take on the risk of staying in the home longer than you expected to. You could end up dealing with the rising interest rate if you can’t sell or refinance.
What You Need to Know Before Taking an ARM
Before applying for an adjustable-rate mortgage, make sure you ask questions like:
- What is the initial fixed-interest rate? How does that compare to another mortgage option, and is it worth taking on a riskier mortgage to get the initial fixed rate?
- How long is the initial fixed rate period?
- How often will the ARM adjust after the initial rate period?
- Are there limits to how much your ARM’s rate can drop?
- How high can the ARM’s rate go? How high can your monthly mortgage payment go?
- If the mortgage’s interest hit the maximum rate, could you afford the monthly payment?
- Do you have a plan for selling the home within the initial rate period if you want to sell before paying the adjusted rate?
- Could you pay off the mortgage without selling if you did not want to pay the adjusted rate?
Do your due diligence and understand the risks and potential pitfalls before making a final decision. But depending on your specific situation, your finances, and your plans for the next 5 years, you could make an ARM work for you.
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