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When Could An ARM Make Sense?

FEATURED | December 6, 2017

When Could An ARM Make Sense?


When interest rates were high, Adjustable Rate Mortgages (ARMs) were popular. The initial interest rates on ARMs are usually lower than for fixed rate loans, so borrowers often hoped that mortgage rates would drop before the ARM adjusted upwards, allowing them to refinance into a lower interest fixed rate loan.  Sometimes this worked, other times it didn’t, but borrowers took the risk. So, when could an ARM make sense?

 

Since the average interest rate on a 30 year fixed rate mortgage (reported by Freddie Mac) has been at or near historic lows since 2009, are there still good reasons to opt for an ARM?  It may make sense in some situations, but you’ll need careful analysis to be sure it’s right for you.

 

Fixed Rate Loan. You’re probably familiar with how a fixed rate home loan works.  You take out the loan for a certain number of years at a certain rate.  The rate is constant over the life of the loan.  You pay interest and principal over time, and at the end of the loan term you own your home free and clear.  If you escrow your property taxes and homeowners insurance (pay them as part of your monthly mortgage payment), you will almost certainly see your payments increase as the cost of these items rises, but your principal and interest payment will stay the same.

 

What is an ARM? As mentioned above, ARM stands for Adjustable Rate Mortgage.  You pay a fixed rate for a limited number of years, and then the rate, tied to a financial index, adjusts at set intervals.  Initial ARM rates are typically lower than fixed rates, but once the adjustments begin, the rate can go up or down.  (Rates have been on the rise recently, but there are caps on how much the rate can rise at each adjustment, and in total.)  Common ARM terms are 5, 7, and 10 years. That means the loan will adjust at the end of 5, 7, or 10 years, not that the loan terminates at that time.  In addition, ARMs are usually described with 2 numbers, such as 5/1, 7/1, 10/1.  The second number tells you how often the loan can adjust.  For example, a 5/1 ARM has a fixed rate for the first 5 years and adjusts yearly thereafter.

 

Why An ARM. An ARM could make sense if you want to take advantage of the lower initial rate and you plan to sell or refinance the home before the loan adjusts.  For example, you may be in a profession that requires frequent relocation.  You may be planning to retire and move in a certain number of years and want to save money with the lower initial rate.  Another reason to opt for an ARM is to take the savings from the lower rate and use the money to pay down the principal on your loan, but this requires you to exercise strong financial discipline.

 

Considerations. An ARM is more complicated than a fixed rate loan.  Here are some things to think about if you are considering an ARM:

  • Rate Adjustments – When is the first adjustment? How often can the rate adjust?
  • Total rate – What is the limit on how high – or how low – the rate can go?
  • Maximum monthly payments – If your loan hits the maximum interest rate allowed, would you be able to afford your monthly payment? The lender will typically underwrite you based on the highest or fully indexed rate, but your financial circumstances may change. Are you prepared to take that risk?
  • Plans change – If you don’t sell or refinance your home before the fixed rate period ends, will you be able to afford the adjusted rate payments? Home values do not always increase and you may not be able to refinance if values are lower.
  • The cost of selling, buying or refinancing. There are costs associated with real estate transactions and home loans. Be sure to factor those in if you are calculating the savings you might see with the lower interest rate on an ARM.

 

If, after reading this general overview, you are interested in an ARM, be sure you work with a trusted Loan Originator who understands both your specific financial goals and the way an ARM works. A First Choice Loan Services Inc. Loan Originator can give you information about a wide range of home loan programs, including ARMs, and advise you on what loans may be right for you.

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We feel very fortunate to have worked with this team.  Thanks for everything you did to help make purchasing our first home possible. -Kathleen B. | Columbus, OH | 4.25.17
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