Adjustable-rate mortgages – commonly known as ARMs – are popular because they typically have interest rates that are lower than what you can get on the 30-year fixed-rate mortgage. But they also carry a considerably greater amount of risk than the 30 year fixed rate mortgage, which is virtually a risk-free loan. So when is an ARM mortgage the right choice?
How ARM Mortgages Work
Let’s start with a brief discussion of how ARM mortgages work. In the most basic sense, an ARM is a mortgage in which the interest rate adjusts each year of the loan. It is set up as a self-amortizing thirty-year mortgage, but the rate will adjust each year based on a lender spread, known as the “margin” (typically in the 2.25% to 2.50% range), plus a popular short-term index, such as the one-year LIBOR index.
Because ARMs are based on a shorter term index than the 30 year fixed rate mortgage – which is typically based on the US 10 year Treasury note – the rates tend to be lower than what they are for fixed rate mortgages. However, to make ARMs more predictable and stable, they come with a fixed rate period that generally lasts for the first five, seven or 10 years of the loan.
After that the fixed rate period, ARMs revert to one-year adjustable terms, in which your rate will change each year. But once again, to make the loan more stable, the adjustments come with limits on how high they can rise, commonly known as “caps.”
A typical cap may be expressed as something like “2/2/5”, or “5/2/5”. Under a 2/2/5 cap arrangement, the maximum your rate can go up on the first rate change is 2%. That means that if your initial rate on a five-year arm is 3.5%, the highest it can go on the first adjustment is 5.5%.
The most that it can rise on any subsequent annual adjustment is also 2%. And the maximum that it can increase over the life of the loan is 5%. So with a 3.5% initial rate, the highest rate you could ever pay on the loan would be 8.5%.
If the ARM has a 5/2/5 cap arrangement, you could be in for a rude awakening. That’s because the initial adjustment can increase your rate as much as 5%. Under that scenario, if your initial rate was 3.5% on a five-year adjustable, it could go to 8.5% at the end of five years. That would more than double your monthly payment.
That’s why ARMs are considered to be riskier loans. The rate can increase substantially over the initial rate that you receive. It’s even possible that you will not be able to afford the payment at some point during the loan term.
Now let’s address the question, when is an ARM mortgage the right choice?
When an ARM Payment is MUCH Lower than the 30 year Fixed
Generally speaking, the shorter the fixed period is on in ARM, the lower the interest rate will be. For example, a five-year ARM typically carries a rate that’s about .75% lower than the rate on a 30 year fixed rate. The seven-year ARM typically carries an interest rate that is about .50% lower than the fixed rate. A ten-year ARM, since the initial term is so long, often carries a rate that is comparable to the fixed rate, which is why it’s a loan that is rarely used.
Considering how small the margin is between the fixed-rate and ARMs, you should be hesitant to take an ARM. For example, if the rate on a 30 year fixed rate loan for $200,000 is 4.00%, the monthly payment will be $955. If the rate on a five-year ARM is 3.25% on the same loan amount, the monthly payment will be $870.
That will result in a savings of $85 per month, or $1,020 per year, or $5,100 over the first five years of the loan.
You have to carefully weigh whether or not a savings of a little over $5,000 justifies the higher risk that you are assuming with the five-year ARM. Considering that the rate could very easily jump to 5.25% at the end of five years, your monthly payment will rise to $1,104. That’s quite a bit higher than what you would pay on the 30 kicks fixed rate. And the rate on the ARM could go higher still from there.
Generally speaking, even if you save money on the monthly payment with an ARM, it should still be taken only if one or more of the following conditions will apply.
When You Expect to Sell the House Before the Adjustable Period Begins
This is the most common justification supporting the use of an ARM. If you were expecting to be out of the house within five years, then a five-year ARM can make sense. That’s because you will sell the house before the adjustable period kicks in.
What’s difficult about this strategy is that you can never know for certain that you will sell the home within five years. An expected job transfer may not materialize. A continued rise in property values may not happen. You may also face personal circumstances that require you to stay in the same property.
When You Expect Interest Rates Will Continue to be Low Forever
ARM loans are also a gamble in which you bet that interest rates will continue to be low or even fall lower in the future. This provides you with two advantages:
- Either you will be able to refinance the loan in five years at a comparable 30 year fixed rate mortgage, or
- Continued low rates will mean that the rate and payment on your ARM will continue to be low, even when the loan enters its annual adjustable phase.
That has actually been the case for people who have taken ARMs for at least the past 30 years. The steady decline in mortgage rates has meant that people with ARMs have been able to ride interest rates down, without having to incur the costs of refinancing.
But if interest rates go into a long term cycle of steady increases, that dynamic will reverse. You will find yourself playing consistently higher rates and monthly payments on the ARM.
Meanwhile, there’s no reliable way to know where interest rates will be in five or seven years. That makes ARMs a real gamble, and you need to seriously consider if you are willing to take that risk on your home.
When You Expect to Have the Mortgage Paid Off Before the Adjustable Period Begins
If there is a financial windfall in your future, one that will be large enough to pay off your mortgage, an ARM makes a lot more sense. You’ll be able to take advantage of the lower monthly payments during the fixed rate period, and then pay off the loan before it ever gets out of hand.
This can even work if you are able to make at least a significant partial payment on the mortgage. Since ARM loans are completely recalculated once an adjustment takes place, that calculation is made on whatever the outstanding balance of the mortgage is at that time.
For example, if you start with a $200,000 mortgage on a five-year ARM, but pay off $50,000 within the five-year term, your mortgage payment will be recalculated based on a remaining balance of $150,000, and not $200,000. The interest rate may be higher, but that may be offset by the much lower principal balance.
This may be the case if you expect to come into an inheritance, exercise employer stock options, or even sell off another piece of property. Just be sure that whatever the source of the windfall is, it’s reasonably certain that it will happen.
If you are considering an ARM, never underestimate the additional risk that you are taking on. You must also be absolutely clear that you are comfortable taking that risk with your home. That’s the reason why most people choose the fixed rate mortgage instead. Realistically, ARMs only makes sense under extraordinarily positive circumstances. Tread lightly!