Before the housing bubble burst nearly a decade ago, adjustable rate mortgages were a good option for many homeowners. However, as interest rates soared, homeowners with ARMs found themselves facing payments they couldn’t afford with interest rates that were much higher than they originally signed up for. As a result, many homeowners lost their homes.
A fixed rate adjustable mortgage is the safest bet for most homeowners. With this type of mortgage, your interest rate is locked in when you get the mortgage. The interest rate remains fixed as does your monthly payment.
However, if you understand the risks with an ARM, there are still benefits to taking one out.
How an ARM Works
You’ll be given a time period when your mortgage will readjust. Terms typically run every 1, 3, and 5 years. For instance, in a 5 year ARM, your interest rate will readjust every 5 years.
Most ARMs have caps or limits to the amount the interest rate can increase as well as the amount your monthly payment can increase. Occasionally, a borrower can reach the monthly payment cap and find that the payment does not cover all the monthly interest. In this case, the balance on the loan begins to increase rather than decrease.
Benefits of an ARM
There are definitely risks to ARMs, and this type of mortgage isn’t right for every borrower. However, there are important benefits to this type of mortgage.
A lower interest rate. One of the biggest attractions of an ARM is that it often offers a lower interest rate initially than a fixed rate mortgage. This teaser rate is what attracts many borrowers. If you have a 5 year term ARM, you can benefit from the lower interest rate for quite a few years.
A lower monthly payment. Thanks to the lower interest rate, a borrower with an ARM will initially have a lower monthly payment. There are two benefits to this –
First, qualifying will likely be easier than if you had instead applied for a fixed rate mortgage (and faced a higher monthly payment). Since the lender uses the monthly payment to determine debt-to-income ratio, a lower payment decreases the amount of debt you have compared to your income and makes it more likely you’ll be approved for a mortgage.
Second, you can likely qualify for a more expensive house when using an ARM rather than a fixed rate mortgage. This is again due to the debt-to-income ratio. Thanks to a lower interest rate and a smaller monthly payment, on paper, you can afford more house.
A frugal option for a temporary resident. If you would like to buy a house but you don’t plan on staying in the house for more than the term of the ARM (like less than 5 years), an ARM may be perfect. You benefit from the lower interest rate and smaller payment, but you’ll sell the house before the ARM readjusts, so you don’t have to be concerned that your interest rate and payment may go up.
A great way to take advantage of falling interest rates. If the interest rate falls considerably over several years and you have an ARM, you automatically benefit when the ARM readjusts. If you had a fixed rate mortgage instead, you’d need to pay to refinance to take advantage of the lower interest rate. An ARM lets you avoid this hassle and expense.
The most important step is to understand the risk should you decide to take out an ARM. If you can understand your risk, you can benefit from this type of mortgage. According to Brent Wilson, a Senior Director of Mortgage Banking at Quicken Loans, “many of the biggest advocates of the program are accountants, engineers, financial advisors, mortgage professionals, teachers, retired, or just great with understanding how the numbers and a good plan will benefit them!”
Click here to see what ARM options may be available for you from Quicken Loans.