Should You Get An Adjustable Rate Mortgage?

by Ron Haynes

Honestly, that depends on your personal situation. Adjustable Rate Mortgages (ARMs) do have their place but they’re not the panacea many mortgage brokers make them out to be. An ARM loan is primarily for people with a specified need for a mortgage and who plan to sell their home before the rate term expires or adjusts.

An adjustable-rate mortgage (ARM) has an interest rate that can change at certain specified and agreed upon points during the term of the loan. Most ARMs offer a fixed rate for a certain period of time (3, 5, 7, or even 10 years), after which the rate adjusts to match current interest rates. Some ARMs have an interest rate adjustment cap (like one percent) over which the rate cannot adjust. For example, if your ARM has a rate of 3.75 percent with a 1 percent adjustment cap, it cannot adjust to more than 4.75 percent on its first adjustment go-around.

Whenever the interest rate adjusts, the amount of your monthly payment will increase (if interest rates rise) or decrease (if interest rates fall – there isn’t much downside risk for rates to fall right now). Like fixed-rate mortgages, ARMs usually come with 15- or 30-year terms. At the end of the term, you will have paid off the original principal plus interest. The total amount of interest that you pay on the loan will vary based on:

  • Interest-rate fluctuations throughout the life of the loan
  • The terms of the loan, such as how often it adjusts

What are the advantages and disadvantages of an ARM loan?

Advantages Disadvantages
Lower initial costs:During an ARM’s fixed term, interest rates and monthly payments are usually lower than those of fixed-rate mortgages. Financial risk: If rates have risen by the time your fixed term ends, your monthly payments on an ARM can increase substantially or even double.
Assumability: Unlike fixed-rate mortgages, many ARMs can be transferred to third parties, which can make your property attractive to buyers looking to assume a seller’s loan. Stress: Some borrowers forgo ARMs in exchange for the peace of mind that comes with fixed-rate mortgages’ permanent interest rates and set payment amounts.

 

How the Interest Rate of an ARM Adjusts

The rate index and margin determine how the interest rate of an ARM adjusts after the fixed-rate term expires.

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  • Rate index: An ARM’s interest rate is tied to one of several rate indexes, such as the interest rates of U.S. Treasury bills or CDs. When the interest rate of the reference index upon which a particular ARM is based rises or falls, so does the interest rate of that ARM. If you’re comparing the index rates of two ARMs, be sure that the loans are based on the same index. The index rate is the interest rate of the ARM, not including the margin (explained below).
  • Margin: The markup that the lender adds to the index rate. The sum of the index rate and markup is called the fully indexed rate. Most lenders add a margin of 2–4 percent, which means that an ARM with an index rate of 5 percent would likely have a fully indexed rate of 7–9 percent.

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If you’re shopping for an ARM, always be sure you’re evaluating the fully indexed rate of a loan, not just the index rate. Also, be wary of loans with teaser rates—introductory interest rates that are usually much lower than the loan’s fully indexed rate but often last as little as one month. Ignore teaser rates entirely and focus on the rate that takes effect once the fixed-rate period of your ARM ends.

Other Characteristics of ARMs

There are a few other key terms you should know as you begin to consider getting an ARM:

  • Adjustment frequency: Once the fixed-rate term expires, ARMs adjust interest rates at certain intervals: some loans adjust every month, while others adjust semiannually, annually, or every few years. If you’re comparing two ARMs, the one that adjusts less often is the better choice, assuming that all other factors are equal.
  • Caps: Caps are limits on the amount that an ARM’s interest rate can adjust from one interval to the next, as well as on the total amount that an ARM’s rate can adjust over the life of the loan. For instance, an ARM may have a 2/6 cap, meaning that the rate can increase or decrease no more than 2% in any adjustment period, and that it can increase or decrease no more than 6% in total over the term of the loan. If you’re comparing two similar ARMs, the one with stricter caps is usually the better choice. Never choose an ARM that doesn’t provide a cap on the loan’s maximum interest rate.
  • Convertibility: Convertibility is a feature that enables you to convert an ARM into a fixed-rate mortgage. Convertible ARMs usually have relatively high fully indexed rates in comparison to other ARMs.

So … should you get an ARM loan?

It’s impossible to answer one way or the other since I don’t know your personal financial situation, but if you plan to be in your home only 5-7 years and you’re confident you’ll be able to sell it when the time comes, an ARM loan may be your best choice.

But if you’re unwilling or unable to sell your home and the rate is about to adjust to a level that makes your payment difficult to make, an ARM loan may be your worst nightmare.

LendingTree offers ARM loans AND fixed rate loans. Your choice!

About the author

Ron Haynes has written 1000 articles on The Wisdom Journal.


The founder and editor of The Wisdom Journal in 2007, Ron has worked in banking, distribution, retail, and upper management for companies ranging in size from small startups to multi-billion dollar corporations. He graduated Suma Cum Laude from a top MBA program and currently is a Human Resources and Management consultant, helping companies know how employees will behave in varying situations and what motivates them to action, assisting firms in identifying top talent, and coaching managers and employees on how to better communicate and make the workplace MUCH more enjoyable. If you'd like help in these areas, contact Ron using the contact form at the top of this page or at 870-761-7881.


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{ 6 comments }

tom

We have a 7/1 ARM.

We refinanced into that knowing that we will be putting our house up for sale in 5 years and that homes in our area have been selling well, especially in our neighborhood.

If you have a strong real estate market, your bank offers caps, and you are only in your home for the short term, an ARM is a very good option.

My personal rule of thumb with ARMs is determine how long you want to be in your home, add 2 years, and that is your ARM. We decided 5, add 2, we got a 7/1 ARM. If you are thinking 7, add 2, round up and go with a 10/1.

The interest rate is increased, but the risk mitigation is well worth it.

reci

Very informative and thanks for sharing facts about Adjustable Rate Mortgage. Will tweet this post to my followers in Tweeter.

Thank you and Happy Easter

AAAMPblog

After 30 years of rising bond price and falling rates the risk/reward ratio for adjustable mortgages is unacceptable. If you KNOW you are going to need the loan only for the period before adjustment then you would save money. But I have seen too many people who have had to change their plans and get burned. The chances that interest rates will be higher over the next few years and the relatively low fixed rates offered today make fixed rate mortgages the overwelming best choice.
Ken Faulkenberry

Kacie

Disappointed with this advice. Interest rates are so low right now, people really should lock in with a fixed rate loan. Have we learned nothing from the housing crisis!? Some houses do take forever to sell, and sometimes you do need to sell at a loss. Interest rates will go up.

I say only get an arm if you are reasonably confident you can pay off the house in it’s entirety before the rates reset.

Ron

Don’t be disappointed! If you’ll reread that last paragraph, you’ll see that your advice and mine match.

ARM loans have their place under very specific circumstances but yes, in today’s interest rate environment a fixed rate makes more sense in almost all cases.

John Neil

I thought this was a very thorough blog post about ARM’s. However I will say that I have never really considered the assumability of ARM’s to be an advantage. I can’t imagine that a lot of home buyers are going to be to excited about assuming an ARM mortgage that is much closer to adjusting than when the sellers took out the ARM. It’s not like the fixed period starts over when the new owners assume the loan.

Overall, a very good article though.

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