The type of mortgage you choose can have a massive impact on your financial situation over the course of the loan. Unfortunately, it’s very difficult to decide which option is best as each have distinct pros and cons. You also can’t predict how your financial situation may change over the years, so when choosing a mortgage, you have to make your best guess at what will work for you now and later.
One important decision you have to make is whether to get a fixed or adjustable-rate mortgage. Adjustable-rate mortgages, or ARMs, have a bad reputation in some circles. While it’s true that they can be riskier than fixed-rate mortgages, they also have their advantages in certain situations. If you’re planning to buy a home soon, you should understand how an ARM works and how you can determine whether or not it’s the right choice for you.
How Adjustable Rate Mortgages Work
An ARM is a mortgage with an interest rate that fluctuates over the lifespan of the loan. Typically, an ARM begins with a fixed interest rate that lasts for a certain number of years. Some guarantee two years of a specific interest rate, some guarantee five, and others may offer more or less time at a fixed rate.
After this window of time expires, the interest rate can vary. Your new interest rates are calculated based on the index, which is a benchmark rate that reflects the current market conditions. Your lender will also add a margin to your interest rate, which is a certain number of percentage points that is added to the index. The index will fluctuate, but the margin is determined when you sign your loan agreement and will not change.
For example, after your fixed-rate period expires, the current benchmark rate may be 4 percent. If your loan agreement includes a margin of 2 percent, your mortgage interest rate will be 6 percent. If the index drops to 3 percent in the following year, your overall interest rate would drop to 5 percent.
Most ARMs update the interest rate every year. Some lenders recalculate the interest rate more frequently, though. You might see a new interest rate every quarter or even every month. The length of each adjustment period should be specified in your loan agreement.
Advantages of ARMs
In your first few years with an adjustable-rate mortgage, you’ll benefit from the predictable, low-interest rate. On average, ARMs have lower interest rates than fixed mortgages during the fixed period. Even a small difference in your rate can make a dramatic difference in the amount of interest you accrue at the beginning of the mortgage. Most of the monthly payments go toward interest, but you could save thousands of dollars in the first couple of years with an ARM.
Building equity in your home is easier when you have a lower interest rate, too. One of the most frustrating situations for homeowners is making mortgage payments for two or three years only to still owe more than you can sell the house for. The lower your interest rate is in the first few years of your mortgage, the more quickly you’ll build equity.
Adjustable mortgages are especially appealing for homeowners who don’t plan on keeping the house for a long time. If you know that you’re going to sell the house in five years, you could benefit from an ARM’s low-interest rate and then sell the home before the interest rate starts to change.
Disadvantages of ARMs
The biggest issue with an ARM is that you can’t predict how your interest rate will change. While ARMs typically have a limit on how much the rate can change, you’re still taking a risk by agreeing to a loan without knowing for sure how much you’ll have to pay. There’s a chance that your interest rate will stay low for the duration of the loan, but you also could face steep interest rates that add thousands of dollars to your debt.
Even if you think you can handle an increased mortgage payment, it’s tough to know with certainty how your budget will be affected by an interest rate change. When your mortgage payment takes up a bigger percentage of your income, you have less money to invest or to set aside for emergencies. If you can’t make the payments, selling or refinancing may be an option, but this should always be a last resort.
Adjustable-rate mortgages have complicated rules, too. It’s essential that you read over the documents thoroughly with your real estate agent or financial advisor to make sure you understand every detail of your agreement. If you miss something or misunderstand something, you could end up with serious problems in the future.
How to Know if an ARM Is Right for You
An adjustable-rate mortgage is not the right choice for everyone. If you’ve budgeted for a specific monthly payment and would be financially strained if your payment were to increase, an ARM is probably too risky. Many homeowners choose a fixed-rate mortgage because they feel much better knowing exactly what their monthly payments will be for the duration of the loan.
However, there are some situations where an ARM can benefit you. If you expect to only own the house for a short time, an ARM could save you money. The interest rate for the first couple of years will likely be lower than what you’d get with a fixed-rate mortgage, but you’ll sell the home before the interest rate increases.
Another situation where it may make sense to get an ARM is if you’re expecting a large influx of cash and plan to use it to pay off your mortgage. For example, if you’ll be receiving an inheritance or a settlement from a lawsuit soon, you could get an ARM while you wait. This way, you’ll have lower monthly payments until you have the funds to pay off the remaining balance.
It can be difficult to decide between a fixed and adjustable-rate mortgage if you’re unsure of your financial future. While a fixed-rate mortgage offers more stability, an ARM can save you a considerable amount of money in some situations. Whatever you decide to do, make sure you’re fully aware of all of the rules and conditions of your agreement. Take your time when reading through the paperwork, and consult with your real estate agent if you have any questions or concerns.
Michael Carr is the Co-Founder & COO of BrandFace, LLC. He is also a real estate branding expert and international bestselling author. As America’s Top Selling Real Estate Auctioneer, he has sold billions of dollars in commercial and residential properties.