The Pros and Cons of an Adjustable Rate Mortgage (ARM)

Mortgage rates on the US for 30-year, fixed rate loans are on the rise. As of July 2018, we are seeing rates around 4.5% and 4.6%. Some experts predict there will be fixed rate mortgages near 5% next year.

It is no surprise then that more potential buyers are eying adjustable rate mortgages or ARMs. ARMs are home loans that have an adjustable rate. An adjustable rate mortgage has a lower rate in the first several years than a fixed rate loan, but the loan rate can go up or down after the lock period ends.

Below is more information about the pros and cons of these mortgages.

The Rate

An ARM is a unique loan product because the rate on the loan can adjust with rates in the marketplace, after the initial lock period expires. Most ARMs loans are available with a 3, 5 and 7-year initial lock period, and can adjust each year after that.

The rate on the ARM will adjust based upon a common market index. One of the most common is the LIBOR index. Another is the prime rate.

The advantage of an ARM with the rate is that you can pay a lot less in interest in the first few years. But after that, the rate can rise. The ARM is a higher risk for you in the long term. With a fixed rate loan, the bank is taking a higher risk because the loan is longer, and the bank will be stuck taking a lower rate if rates rise.

Advantages of an ARM Loan

You will enjoy lower payments in the fixed term of 3, 5 or 7 years. This has the potential to save you thousands in interest in the first few years. Also, the payment that you will pay is predictable in that period.

Second, the ARM is flexible. It can be a good move if you think you are going to move in the next several years. A person who is going to move in three years may want to take advantage of an ARM loan because they will move before the loan resets anyway.

Next, most ARMs have a cap on how high the rate can go. The interest rate cap will limit how much the loan can adjust in one year, and how much it can rise during the entire life of the loan.

Also, if the interest rates decline, there is a possibility you could pay less in a few years than you pay now.

Disadvantages of an ARM Loan

Obviously, the biggest risk is your payment can go up in the long term. Rates have generally been on the increase in the past 18 months, so there is a good chance that your payment could go up in the coming years. It is hard to know how much rates could rise. This introduces a degree of unpredictability in your finances that some people do not want.

Second, life has a way of going in ways we did not predict. You may think that you will definitely be making more money in three years and you will be able to afford a higher payment. But what if the economy tanks and you lose your job? You may have a payment you cannot afford, and you cannot sell the house quickly. If you are unable to make the payments, you will lose the home and damage your credit. This is what happened to millions of home owners during the last downturn.

Third, an ARM is simply unpredictable. This fact makes it a poor choice for financially conservative people. Those who will have difficulty sleeping at night because they have a variable rate mortgage may want to reconsider. Even if you are tempted to go for the initial lower payment of an ARM, you may not want to do it because it causes you stress.

The bottom line on the ARM is it is a useful loan product to use for some people who want to have a lower interest rate initially. It can make sense if you are confident that you will sell the home before the loan resets, or you will be making enough money by then to afford the higher payment.