With mortgage rates the lowest they’ve been in a year, it’s good news for any borrower with an ARM loan and prospective home buyers who are shopping around for a new mortgage. Adjustable-rate mortgages (ARMs) typically offer some of the lowest initial rates available out of any type of mortgage, and those low payments at the beginning of the mortgage can be a boon for first-time home buyers. There’s a lot to take into consideration as you consider whether it’s worth it for you to take out an ARM loan, but it’s often the math that wins the argument.
What Is an ARM Loan?
Adjustable-rate mortgages have less risk for the lender as rates can increase over time, so they generally come with lower interest rates than fixed-rate mortgages. The rate remains fixed for a set period of time at the beginning of the loan (usually three, five or seven years). After the initial period, the interest rate can increase or decrease depending on the lender’s going rate. The adjustments take place at specific intervals, usually every six months to one year.
ARM loans do have caps on how much the interest rate can increase at any given adjustment period as well as how much it can increase over the life of the loan. These caps are put in place to safeguard borrowers from skyrocketing rates.
Is There Risk Involved in an ARM Loan?
Though the risk of an ARM loan is lessened for the lender, there is a risk to the borrower. Let’s say that you take out a 30-year $200,000 ARM loan at 3 percent with a five-year fixed-rate period and adjustments each year. The loan has a two percent cap at each adjustment period and a six percent lifetime cap.
At the beginning of the mortgage, your payments are only $843.21 without taxes and insurance. But let’s say that the rates jump the full two percent in year six; that means your payments just jumped to $1,073.64. Over the next 15 years or so, interest rates continue to rise and you hit the six percent cap. That means that your once-low mortgage payment is now $1,609.25.
Keep in mind that if your interest rate increases at all during the life of your ARM loan, it’s going to slow down the rate at which you’re accumulating equity. This can be problematic if you need to take out a home equity loan or home equity line of credit. Even more importantly, if home values in your area start to go down, you could find yourself in a precarious position with an underwater loan. Even if your loan doesn’t go underwater, a lack of equity could mean that you’re not qualified to refinance your home if you need to.
Sure, you can always refinance, but that costs money, and it’s possible that you might refinance at a higher rate than you would have had if you had just taken out a fixed-rate loan in the beginning.
Are There Benefits to Taking Out an ARM Loan?
Despite the risks, taking out an ARM loan is the right move in many cases. The average U.S. homeowner only stays in the home for seven years, making a 7/1 ARM (seven-year fixed-rate period followed by annual adjustments) a good choice. If you do sell at the end of the seven-year period, you will have had the benefit of a fixed-rate mortgage, but at a significantly lower interest rate. On a $200,000 ARM loan at three percent, you’ll save more than $13,000 in interest during that seven years over a similar fixed-rate loan at four percent.
Are There Alternatives to ARM Loans?
For home buyers who don’t plan to stay in the home over the long term, a shorter-term fixed-rate loan offers an alternative for those who don’t want to gamble with an ARM loan. Fixed-rate loans with shorter terms generally carry lower interest rates than 30-year fixed-rate mortgages. For example, if you plan to stay in the home for seven years, a 10-year or 15-year fixed-rate mortgage might be the right choice for you.
The mortgage payments on a 15-year fixed-rate mortgage of $200,000 at 3.5 percent are $1,429.77. At the end of seven years when you’re ready to sell, you’ll only owe $120,000 on your mortgage and your total interest paid is just under $40,000. If you had taken out a 30-year fixed-rate mortgage at four percent instead, you would owe more than $170,000 at the end of seven years, and you would have paid more than $50,000 in interest during that time.
The bottom line is that if you’re not willing to take the risk on an ARM, even with the lower rates, then don’t take a term on a fixed-rate mortgage that’s much longer than you need.
How Do the Low Rates Impact My Existing ARM Loan?
If you’re well into an existing ARM loan, you could be in luck. Depending on how long you’ve had the loan and what the interest rates were when you took it out, you could see your loan’s interest rate decreasing. Even if they don’t decrease, they certainly won’t increase at your next adjustment period. If you manage to get through your ARM loan without an increase, then you’ve hit the jackpot, as that’s the equivalent of taking out a fixed-rate mortgage at lower than the going rate. If you’re not really a risk taker, you may want to consider refinancing into a fixed-rate loan to lock in the lower rates.
2 Point Highlight
If you’re well into an existing ARM loan, you could be in luck.
Adjustable-rate mortgages (ARMs) typically offer some of the lowest initial rates available out of any type of mortgage, and those low payments at the beginning of the mortgage can be a boon for first-time home buyers.
