When an Adjustable Mortgage Rate Can Actually be a Smart Move

When an Adjustable Mortgage Rate Can Actually be a Smart Move
Written by Publishing Team

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Although mortgage rates have risen in recent weeks, they are still close to historic lows.

However, that may not be enough to prevent homebuyers from worrying about rising costs. The Federal Reserve’s recent announcement of plans to raise interest rates next year may make you wary of taking out an adjustable-rate mortgage (ARM), even if it comes with low interest initially (also known as a teaser loan).

“Rates have been trending a little bit higher, and there is 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. “Although the rates may be higher, there are still some situations where ARM might make sense.”

Adjustable mortgages, even in today’s conditions, have advantages. For example, short-term homeowners can take advantage of ARM, along with anyone who plans to pay off their mortgage faster than the standard 30-year period.

But adjustable rate mortgages come with risks. Before making a decision, consider your situation, including how long you plan to live in your home and whether it’s primary accommodation or rental property. Before that, we review when ARM might be a smart move and when it isn’t.

What is an Adjustable Mortgage (ARM)?

An adjustable mortgage–commonly called an ARM–is where the interest rate changes over time. On the other hand, a fixed rate mortgage has one interest rate for the life of the loan.

“ARM can go up or down,” says Tabitha Mazara, COO of mortgage lender MBanc. “From current rates, though, ARM has nowhere to go but upside.”

Mazara explains that most ARMs have a fixed period as well as an adjustable period. For example, you might see 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 thereafter.

ARM prices are often based on what’s happening in the markets and are influenced by a specific benchmark that reflects current market conditions, Parker says. Lenders usually calculate mortgage rates whatever the federal standard, set by the Federal Reserve, plus whatever margin it sets the rates by that particular day or week.

professional advice

Plan to replace your ARM when the initial fixed rate period expires since your monthly payments change.

ARM vs. Fixed Rate Mortgage

When comparing the interest rate on a mortgage loan versus a fixed-rate mortgage, the biggest difference is the interest rate, says Mazara. ARM often has a lower initial rate than a fixed rate mortgage. This can make ARM attractive because the initial payments can be lower, allowing you to better fit the mortgage into your budget. However, a fixed rate mortgage is more predictable because the payment will not change, no matter what happens to interest rates in the future.

an arm fixed exchange rate
Interest rate Fixed for a specified period of time, then reset at regular intervals It remains the same for the life of the loan
Initial interest rate less often usually higher
monthly payment Changes based on the interest portion of the payment It remains the same for the life of the loan

When is an adjustable mortgage a smart move?

Although there are upside risks for ARM, both Parker and Mazzara say it makes sense to get an adjustable mortgage, depending on your situation.

short term home owner

For those who know they’ll be moving out of the house before the humor period ends, ARM can make sense.

“It usually 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 are going to move in in three to five years. They know they are going to sell the property and that the low interest rate with the low payment makes sense to them.”

Some experts say you can only buy if you know you’ll be in a home for at least seven years, but Mazarra points out that’s not always the best financial advice. To decide, review the rental rates in your area. Compare them to what your monthly mortgage payment would be, and think about what kind of appreciation you would see if you bought a home in that particular location. Depending on the market, you can save money on your purchase, even if you’re only at home for a short time.

Expected increase in income

Another example in which ARM can work for homebuyers is when they expect a rise in their income. Whether they are expecting a big bonus or working on commissions, ARM can benefit those who plan to make lump sum payments annually while their ARM rate is low.

“These homeowners know, at the end of the year, that they’re going to be making big payments on the basic payments at the end of the year,” Parker says. “Take advantage of the lower initial price and pay it faster.”

Towards the end of the initial period, the homeowner can refinance at a fixed rate. At this point, the capital is lower, and the homeowner may decide to opt for a shorter term. This strategy can be effective in helping a homeowner pay off their mortgage debt faster—while saving money on interest.

Expect to pay off the mortgage during the teaser period

Finally, if you expect to pay off the mortgage during the teaser period, ARM can make sense. You save money on interest and don’t have to worry about adjusting the rate higher because the loan has been paid off.

This is important, and experts warn that life events can derail this plan. But if you know for sure that you can pay off the loan during the teaser period, it might be worth the risk, says Parker.

Other Considerations Before Getting an Adjustable Mortgage

Given the low price environment we currently live in, mortgage rates are likely to rise over time. As a result, both Parker and Mazarra suggest that flat rate may be the best option at the moment.

“Prices could go up soon. So being closed off right now makes sense, Parker says. “You know your payment won’t change, and as prices go up, you won’t end up paying more later.”

Mazarra says fixed-rate mortgages are especially great when you know you’ll be staying in your home for an extended period of time — even if you think you can save a few bucks with a lower ARM rate.

“If you’re buying your home for 30 years forever, or you’re buying a home that you might move out of but still keep as a rental income property, it’s not a good idea to take out an adjustable rate mortgage,” says Mazarra. “If you’re buying your home for the long-term, don’t go with ARM, because you don’t want to have to worry about that upside risk.”

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