Unless you have hundreds of thousands of dollars to spend, chances are you’ll have to take out a mortgage to purchase a home. As a cost for extending the mortgage to you, the bank will charge interest based on an interest rate. If your interest rate stays the same over the life of the loan, you have what’s known as a fixed rate mortgage, FRM. On the other hand, if your interest rate fluctuates during the life of the loan you have an adjustable rate mortgage, ARM.
Pros and Cons
What attracts many homebuyers to adjustable rate mortgages is the low initial cost of the mortgage. Most ARMs start off with a low interest rate that makes mortgage payments more affordable than a fixed rate mortgage in the first few years of the mortgage.
To approve your mortgage application, the bank looks at a few of your financial facts, including your credit history and income. If you don’t have good credit, you might qualify for an adjustable rate mortgage when you don’t qualify for a fixed mortgage. For some homebuyers, an adjustable rate mortgage is the only choice.
The downside of an adjustable rate mortgage is that payments fluctuate over time and typically increase. While you know the timing of these increases, you can’t predict the amount of the increase. If your income doesn’t increase to compensate or you don’t reduce your budget in other areas, your mortgage can easily become unaffordable. This is drastically different from a fixed rate mortgage where your payments will remain the same over the life of the loan. You never have to question if and when your payment is going to increase.
Types of ARMs
- A hybrid ARM is a cross between a fixed rate mortgage and an ARM. The first few years of the mortgage has a fixed interest rate, followed by an adjustable rate for the remainder of the mortgage.
- An option ARM gives the borrower a choice of payment amounts between interest-only payments or a minimum payment that’s below the interest-only payment. The interest rate on an option ARM mortgage adjusts on a monthly basis and the payment on a yearly basis.
- With an option ARM there is the risk of negative amortization. This happens when monthly payments don’t cover the interest on the loan resulting in an increasing (rather than decreasing) mortgage balance.
- An interest-only ARM is one in which the borrower only makes interest payments on the mortgage.
Is an Adjustable Rate Mortgage Right For You?
Despite the drawbacks, there are situations where an adjustable rate mortgage is a smarter decision. If you’re planning to resell your home within five to seven years, an adjustable rate mortgage might be a better option.
If you expect your income to increase over time, an adjustable rate mortgage could be a good decision. You’ll have the convenience of lower initial payments and the comfort of knowing you’ll be able to afford payments when they increase.
You might consider choosing an ARM based on the initial lower mortgage interest rate. You might only be able to afford the monthly payments on a lower interest rate mortgage. Although the initial low payment might be attractive, there is the risk that interest rates will rise putting mortgage payments outside your budget. This type of situation recently occurred in the mortgage industry causing many homeowners to have their homes foreclosed. Some experts believe the drastic increase in foreclosure rates has spiraled the economy into a recession.
If you consider an ARM, pay attention to any interest rate caps, also called charge limits. These cap is a maximum limit on the amount of interest you can be charged. You can use this cap to decide if the highest possible mortgage payment is within your budget or not.