How to Decide if an Adjustable-Rate Mortgage Is Right for You

Even with the promise of lower mortgage rates on the horizon, you may still need to find a way to lower your borrowing costs. An adjustable-rate mortgage (ARM) provides a path to achieve this goal, but it’s an option that comes with risks.

Unlike a fixed-rate mortgage that has the same interest rate and payment for the entire loan term, ARMs have variable interest rates and payments that fluctuate with shifts in the market. That uncertainty means more risk for the borrower. But it also translates into lower interest rates and more affordable monthly payments during the initial years of the loan.

ARMs are less common than fixed-rate loans. Over the past decade, only 5% to 15% of borrowers have chosen an adjustable rate. According to the latest Mortgage Bankers Association (MBA) weekly applications survey, 5.4% of recent mortgage applications were for adjustable-rate loans.

Is an adjustable-rate mortgage right for you?



Before opting for an ARM, you need to understand how adjustable-rate mortgages work. Most adjustable-rate mortgages are hybrid ARMs, which have two periods or stages: an initial period and an adjustable period.

* Initial period: During the initial period, the interest rate and principal-and-interest payment remain fixed, typically for six months or three, five, seven or 10 years.
* Adjustment period: During the adjustment period, the interest rate and payment adjust up or down (or remain the same) at predetermined intervals, such as every six months or every year.




The most common type of ARM is the 5/1 ARM, which means the interest rate is fixed for five years and adjusts annually after that. Besides hybrid adjustable-rate mortgages, other types of ARMs include interest-only and payment-option ARMs, which are not widely available.

The risks



While your ARM will have interest rate caps to prevent unmanageable increases during a rising interest-rate environment, you’ll likely still be faced with increasing monthly payments once your adjustment period hits. This can put a strain on your household budget.

Because of the risk, qualifying for an ARM is often more difficult than with a conventional 30-year mortgage. You may need a higher down payment and better credit score. Your income also needs to be high enough to qualify at a higher interest rate than you initially receive.

When to consider an adjustable-rate mortgage



Despite the risks of adjustable-rate mortgages, they could be a good strategy in some scenarios. If you plan to sell, refinance or pay off the loan before the rate adjusts, your monthly savings can be applied to other financial goals. You can also use it to make additional payments toward your principal, increasing the amount you’ll net if you decide to sell your home. 

Just keep in mind that market shifts could affect your ability to sell or refinance. Also, some ARMs come with a prepayment penalty. This fee can reduce your savings if you refinance or sell your home during the initial period and pay off the loan early.

When determining whether an ARM will work for your situation, compare the costs of an ARM versus a fixed-rate loan using an adjustable-rate mortgage calculator. Make sure to account for the impact of any prepayment fees on the savings an ARM might provide over a fixed-rate loan.

Pros and cons of adjustable rate mortgages






Pros

Cons



●     Provide a lower initial interest rate and payment

●     Typically have an initial fixed period

●     Rate caps limit how high the rate and payment can adjust

●     Interest rates and payments can decrease if rates drop

●     Interest rates and payments can increase considerably

●     Can be risky and unstable

●     Some ARMs have stricter borrower requirements, such as a higher down payment and credit score minimums

●     Prepayment penalties, when included, can reduce the initial savings | bit.ly/3XLoEJb


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