An adjustable rate mortgage, or ARM, can help some home buyers save money during the first few years of their loan. But do the short term savings outweight the risks? It depends on the borrower. For some borrowers, an adjustable rate mortgage can be a great way to maintain low mortgage payments while building wealth in other ways, such as career advancement or flipping the house for a profit. For others, an ARM can present a dangerous risk of facing future high mortgage payments that they weren’t prepared for.
So, how do you know which category you fall into?
Ask yourself how you feel about risk. Are you the type of person who is willing to risk the possibility of paying more money later on in exchange for lower payments in the short term? If so, are you ALSO someone who can afford higher payments, should they be required?
If you answered yes to both questions above, then an ARM may be a good option for your home financing needs.
On the other hand, if you are someone who would feel more comfortable sticking with a steady payment month in and month out – not enjoying the savings of a low payment early on, but enjoying the security of never having your payments increase, then a fixed rate mortgage may be a better choice.
Still not sure? Review the following pros and cons to help determine whether or not an adjustable rate mortgage is right for you.
1. Low Introductory Rate Terms
Adjustable Rate Mortgages can offer lower-than-average interest rates for the first few years of the loan. This is typically referred to as an introductory rate period. Usually, ARMs offer introductory rate periods of 3, 5, 7 or even 10 years. Not all mortgage lenders offer all terms, but 3, 5 and 7 years are pretty standard. During this low introductory rate term, your mortgage rate will remain the same. For example, if you have a 3 year ARM, your introductory rate (sometimes called a teaser rate) will remain the same for the first 3 years of the mortgage.
2. Short Term Savings
If you’re not planning on owning the home more than a few years, a 3 or 5 year ARM may be a good choice, due to the fact that you’ll likely enjoy substantial short term savings. This is one reason 3 year ARMs and 5 year ARMs are popular among investment property buyers. House flippers, who purchase a home with the intent to fix it up and resell it for a profit within 12 months, also often choose 3 or 5 year ARM loans. This allows them to maintain low monthly payments for the first few years in case their flip doesn’t sell right away.
3. Ability to Refinance
What if you don’t know how long you’ll own the home? Or what if your life circumstances change, preventing you from selling your home as soon as you had hoped. ARM borrowers may be able to refinance their home loan into a fixed rate mortgage before their introductory rate period expires, helping them avoid a rate increase and having to make higher monthly payments.
A word of caution: Refinancing will largely depend on how much equity you’ve been able to build up since buying the home. (Equity is your home’s current market value minus what you currently owe on your mortgage). For example, if you owe $40,000 on your mortgage and it’s worth $100,000, then you would have $20,000 in equity (or 20%). How much equity you need to refinance can vary based on the type of loan you have and the type of loan you want to refinance into. In most cases, you’ll need at least 20% (which is why most experts say you should try to make at least a 20% down payment if you think you’ll want to refinance later on).
1. Risk of Higher Payments
The single biggest drawback to choosing an adjustable rate mortgage is the risk of having higher payments after the introductory rate period expires. For example, if you have a 3 Year ARM, after the 3rd year, your rate will be subject to adjustment. Usually this adjustment happens once a year for the remainder of your mortgage. That means on the 4th year of owning your home, you could have a much higher mortgage payment. How much higher depends on the index, margin and caps associated with your loan. This is where it can get a little complicated, so be sure to discuss adjustable rate caps with your lender. By law, your lender is required to disclose the true cost of your mortgage, including the maximum payment amount possible if your rate should ajdust. Refer to the section pertaining to Adjustable Rate Mortgages (page 52) in the Consumer Financial Protection Bureau’s Truth In Lending Act Laws and Regulations document here: https://s3.amazonaws.com/files.consumerfinance.gov/f/201503_cfpb_truth-in-lending-act.pdf
2. May not be able to refinance
As noted above, refinancing is not a free pass to get out of an adjustable rate mortgage. It usually requires at least 20% equity in your home. Refinancing also comes with certain closing costs, so it can be costly to do. It may also sets the clock back, so to speak, setting your equity back to zero. For example, if you have 20% equity in your home and refinance to a fixed rate mortgage, that 20% may need to be used for the down payment on your refinance. That depletes your equity and now you’re back to square one.
3. Tax implications
Although not considered a huge disadvantage, having an ARM (and therefore, likely a considerably lower interest rate) means you will have paid less interest over the course of the introductory term. That means you won’t be able to take advantage of as significant a deduction when you do your taxes. Homeowners can deduct the interest they pay on their homes, with some restrictions. By paying less interest, you won’t have as large of a deduction come tax time. Consult your tax professional for details.
Want to Learn More?
Would you like to learn more about adjustable rate mortgages? Please don’t hesitate to contact Trilogy Mortgage for more information and a free rate quote.