Adjustable-Rate Mortgage: The Pros And Cons To Consider

An adjustable-rate mortgage (ARM) is a home loan with a variable (or adjustable) interest rate. But should you consider getting one?

To make an informed decision, you need to understand the nuances of how ARMs are structured. Then you can assess the pros and cons and how they’ll fit with your home loan goals.

How Do Adjustable-Rate Mortgages Work?

An ARM is a type of home loan with an interest rate that fluctuates over time. The interest rate on an ARM is typically fixed for an initial period, usually ranging from 1 – 10 years, and then adjusts periodically based on market conditions.

ARMs tend to be more popular in periods when overall interest rates are higher. That’s because borrowers typically get a lower initial interest rate on an ARM than with a fixed-rate mortgage. This “initial” rate expires at the end of the fixed period.

Once the fixed period ends, your interest rate will be adjusted according to market conditions. This can cause your monthly mortgage payment to increase or decrease dramatically. This uncertainty is part of the risk associated with ARMs.

To help protect borrowers, ARMs come with caps as part of the loan agreement. These caps limit how much your interest rate can increase during the adjustment periods.

• Initial adjustment cap: Limits the amount your interest rate can increase in the first adjustment after the fixed interest period ends.
• Subsequent adjustment cap: Limits how much your interest rate can increase in subsequent adjustment periods.
• Lifetime adjustment cap: Limits how much your interest rate can increase in total over the life of the loan.

The cap thresholds will vary depending on the lender you choose. Lenders can also include caps that limit how much your interest rate can decrease over the life of the loan.

What Are The Pros And Cons Of An ARM?

Here are the advantages and disadvantages to consider for home buyers who want an ARM.

Pros

Lower Introductory Interest Rates

ARMs typically offer lower introductory interest rates than fixed-rate mortgages. The initial fixed-rate period ranges from 1 – 10 years. This lower rate results in lower monthly mortgage payments during the initial period.

Initial Savings

Due to the lower introductory interest rates, ARMs provide borrowers with lower initial monthly payments than fixed-rate mortgages. This way, homeowners have freed-up funds for other expenses or savings.

Interest Rates Could Decrease

Your ARM’s interest rate could remain low (or go even lower) after the introductory period. For example, say your initial rate expires after 5 years. If market conditions drop interest rates below what you received when you first bought your home, your monthly payment lowers.

Rate Caps

The degree to which your interest rate can increase will be limited by rate caps. This provides some level of protection if interest rates should surge after you sign the loan. With Rocket Mortgage®, your ARM rate can never go higher than 5% above your initial rate.

Ability To Refinance

Another advantage of ARMs is the potential to refinance the loan before the introductory rate expires. Refinancing can enable borrowers to secure a fixed interest rate, providing them stability and predictable payments for the remainder of the loan term. As a result, borrowers who refinance their ARM can shield themselves from variable rate increases several years down the line.

Cons

Interest Rates Could Increase

After the initial fixed-rate period, the interest rate on an ARM is adjusted periodically based on changes in the chosen financial index. Therefore, borrowers risk receiving rising interest rates. If market conditions or the index value increases, the interest rate on the ARM can also rise, potentially resulting in higher monthly mortgage payments.

Less Stability

Unlike fixed-rate mortgages, ARMs lack the stability of a constant interest rate throughout the loan term. The uncertainty associated with changing interest rates can create financial challenges for borrowers. This drawback can make budgeting and financial management more difficult, particularly for individuals with fixed incomes or tight financial constraints.

Could Cost More Long-Term

Despite the initial savings from the teaser interest period, interest rates could significantly increase over the life of your loan. In the long run, you could end up paying much more in interest than you would have with a fixed-rate loan.

Is An Adjustable-Rate Mortgage Right For You?

An ARM can be a good option if you want to buy a home in specific situations. Here are some scenarios where an ARM may be suitable:

1. Short-term homeownership plans: An ARM can be particularly advantageous if you intend to stay in your new home for fewer years than the initial fixed-rate period of the ARM. You’ll benefit from the lower introductory interest rates during the fixed-rate period, then sell the property or refinance the mortgage before the adjustable phase begins. This way, you can take advantage of the lower initial payments and avoid any potential interest rate increases in the future.
2. Anticipated income increase: If you expect your income to increase significantly before the initial rate expires, an ARM can help you manage your monthly expenses until your income rises. However, it's essential to assess your financial situation and future income growth to ensure you can handle potential payment increases once the adjustable phase begins.
3. Anticipated drop in interest rates: By initially securing a lower interest rate, home buyers take advantage of the savings during the fixed-rate period. Then, if interest rates drop, you can refinance into a lower fixed-rate mortgage or continue with the ARM if the adjustable rates remain favorable. Just remember this is a risky strategy and nobody can predict with certainty what interest rates will do.
4. Investment property: Investors planning to sell the property before the fixed-rate period ends can benefit from lower initial interest rates and monthly payments. This way, you'll have more cash flow during the introductory period. In addition, you can sell the home before the initial rate expires to avoid the monthly payment jump.

The Bottom Line: Consider All Pros And Cons Of An ARM

The main tradeoff of ARMs is they offer lower initial interest rates with the risk of increasing rates in the future (depending on market conditions). If you’re comfortable with that risk, an ARM might be a good option. Alternatively, if you plan to refinance or sell your home early in the loan term, an ARM still might be a good choice.

If you’re interested in pursuing an ARM, get started with the approval process today.