Even though mortgage rates have been creeping up in recent weeks, they’re still near historic lows.
Yet that may not be enough to keep homebuyers from worrying about rising costs. The recent announcement from the Federal Reserve with plans to raise interest rates next year might make you wary of taking out an adjustable rate mortgage (ARM), even if it comes with low interest at first (also known as a teaser loan).
“Rates have been trending up a bit, and there’s speculation that we will see higher rates in the next few years,” says Kevin Parker, vice president of field mortgage lending at Navy Federal Credit Union. “Even though rates are likely to rise, there are still some situations where an ARM might make sense.”
Adjustable-rate mortgages, even in today’s conditions, do have perks. Short-term homeowners, for instance, could stand to benefit from an ARM, along with anyone who plans on paying their mortgage off faster than the standard 30-year period.
But adjustable rate mortgages come with risks. Before deciding, consider your situation, including how long you plan on living in your home and whether it’s a primary residence or rental property. Ahead, we review when an ARM might be a smart move and when it’s not.
What Is an Adjustable-Rate Mortgage (ARM)?
An adjustable-rate mortgage — usually called an ARM — is where the interest rate changes over time. On the other hand, a fixed-rate mortgage has a single interest rate for the entire life of the loan.
Most ARMs have a fixed period in addition to an adjustable period, Mazzara explains. For example, you might see a 5/1 ARM. In this arrangement, you have a set interest rate for the first five years of the mortgage, and the interest rate changes once per year after that.
ARM rates are often based on what’s happening in the markets and are influenced by a specific benchmark that reflects current market conditions, says Parker. Lenders usually calculate mortgage rates as whatever the federal benchmark is, determined by the Federal Reserve, plus whatever margin they adjust rates by on that given day or week.
Make a plan to replace the ARM when the initial fixed-rate period ends since the monthly payments will change.
ARM Vs. Fixed-Rate Mortgage
When comparing an ARM vs. fixed-rate mortgage, the biggest difference is the interest rate, says Mazzara. An ARM often has a lower initial rate than a fixed-rate mortgage. This can make an ARM attractive because the initial payments might be lower, allowing you to better fit a mortgage into your budget. However, a fixed-rate mortgage is more predictable since the payment won’t change, no matter what happens to interest rates in the future.
|Interest rate||Fixed for a set period of time, then resets at regular intervals||Remains the same for the life of the loan|
|Initial interest rate||Often lower||Usually higher|
|Monthly payment||Changes based on the interest portion of the payment||Remains the same for the life of the loan|
When Is an Adjustable-Rate Mortgage a Smart Move?
Even though there’s upside risk to an ARM, Parker and Mazzara both say it can make sense to get an adjustable-rate mortgage, depending on your situation.
For those who know they’ll move out of a home before the end of the teaser period, an ARM can make sense.
“Typically it comes down to whether you have changes coming in the next few years,” Parker says. “We see a lot of military borrowers who know they’ll move in three to five years. They know they’ll sell the property and a low interest rate with low payment makes sense for them.”
Some experts say to buy only if you know you’ll stay in a home for at least seven years, but Mazarra points out that this isn’t always the best financial advice. To decide, review the rental rates in your area. Compare them to what a monthly mortgage payment would be, and consider what kind of appreciation you might see if you bought a house in that particular location. Depending on the market, you could save money when you buy, even if you’re only in the home for a short period of time.
Expected Bump In Income
Another instance in which an ARM could work in homebuyers’ favor is when they expect a bump in their income. Whether they expect a big bonus or work on commissions, an ARM could benefit those who plan to make annual lump sum payments while their ARM rate is low.
“These homeowners know at the end of the year, they will make lump sums on principal payments at the end of the year,” Parker says. “Take advantage of the initial lower rate and pay it down faster.”
Toward the end of the initial period, the homeowner can potentially refinance to a fixed rate. At this point, the principal is lower, and the homeowner might decide to choose a shorter term. This strategy can be effective at helping a homeowner pay off the mortgage debt faster — while saving money on interest.
Expect to Pay Off Mortgage During Teaser Period
Finally, if you expect to pay off the mortgage during the teaser period, an ARM can make sense. You save money on interest and you don’t have to worry about the rate adjusting higher because you have the loan paid off.
This is a big if, and experts warn that life events could derail this plan. But if you know for sure you can pay off the loan during the teaser period, it could be worth the risk, says Parker.
Other Considerations Before Getting an Adjustable-Rate Mortgage
“Rates could go up soon. So locking in right now makes sense,” Parker says. “You know your payment won’t change, and as rates rise, you won’t end up paying more later.”
Fixed-rate mortgages are particularly nice when you know you’re going to be in your home for an extended period of time, Mazarra says — even if you think you could save a few bucks with a lower ARM rate.
“If you’re buying your 30-year forever home, or buying a home you might move out of but still keep as an income rental property, it’s not a good idea to take an adjustable-rate mortgage,” Mazarra says. “If you’re buying your long-term home, don’t go with an ARM, because you don’t want to have to worry about that upside risk.”