Adjustable Rate Mortgage Pros and Cons

For people who are getting a home loan this year, you may know that you are probably buying in a time of rising interest rates. While interest rates will not rise through the roof, you can expect to pay more for a mortgage in six months than today. There are millions of people who have benefited when refinancing adjustable mortgage rates, but people need to understand what they are getting themselves into when signing the paperwork.

Adjustable Rate Mortgages Offer Low Payment Options with Risks

• Low Intro ARM Mortgage Rates Are Attractive
• Reduced Monthly Payments with Variable Rate Mortgages
• Increased Cash Flow Opportunities with Hybrid ARM Loans

As that is likely the case, you may want to think about getting an adjustable-rate mortgage, or ARM. While some people may think that getting an ARM loan is ‘risky,’ this is really not the case most of the time. Some ARM loans got a bad rap in the mortgage meltdown, but there have been changes with ARM’s today and for many people, they are a good bet. Most Americans will discover that they will be able to save themselves big each year.

Risk Versus Reward for Adjustable Rate Mortgage Loans

When it comes to choosing a mortgage, borrowers are faced with various options.

Among these, variable rate loans offer a unique risk-reward dynamic.

Unlike fixed-rate mortgages, where the interest rate remains constant throughout the loan term, variable rate mortgages (also known as adjustable-rate mortgages or ARMs) have interest rates that can change periodically.

This article explores the concept of variable interest mortgages, their risks, potential rewards, and when they might be a suitable choice for borrowers.

Popular Adjustable Rate Mortgage ARM Terms

When interest rates are trending upward, there are few reason to lock into a fixed rate. During these periods, savvy borrowers migrate towards hybrid mortgages that incorporate ARM interest rates. These unique ARM loans offer a fixed rate for a specified period before they adjust.

3-year ARM sometimes provides a lower mortgage rate than the 5-year ARM, but typically it’s the same variable interest rate. The adjustable rate period starts after the 36 months.

5-year ARM typically offers the lowest interest rates and monthly payments for the initial rate period. These hybrid loans are well-suited for borrowers who anticipate moving or refinancing within five years. The initial fixed rate period ends after 60 months.

7-year ARM offers seven years of stable monthly principal and interest payments at a low initial rate before any rate adjustments occur. This 7-year fixed rate term is beneficial for those who plan to move or refinance within the seven-year timeframe.

10-year ARMs are growing in popularity as these hybrid mortgages provide substantial savings during the initial rate period while also offering extended protection against market fluctuations in interest rates. The adjustment period begins after 120 months, so that gives you plenty of time to refinance before the rate changes.

Understanding Adjustable Rate Mortgage Loans (ARMs)

Variable rate mortgage loans are characterized by fluctuating interest rates. These rates are often tied to an underlying financial index, such as the Prime Rate, the London Interbank Offered Rate (LIBOR), or the Cost of Funds Index (COFI). The interest rate on a variable rate loan typically adjusts periodically, usually after an initial fixed-rate period.

The Risks

Interest Rate Fluctuations: The primary risk associated with variable rate mortgage loans is the unpredictability of interest rate changes. When market interest rates rise, the interest rate on a variable-rate mortgage can increase, leading to higher monthly mortgage payments.

Payment Uncertainty: Variable rate mortgages offer lower initial interest rates during the fixed-rate period, making them more affordable. However, as rates adjust, borrowers face uncertainty regarding future payment amounts. Monthly payments may increase, potentially causing financial strain.

Budgeting Challenges: The fluctuating nature of adjustable rate mortgages can make long-term budgeting and financial planning more challenging. Borrowers must be prepared to adapt to changing circumstances.

Risk of Negative Amortization: Some variable rate mortgages have provisions that allow unpaid interest to be added to the principal balance (negative amortization) when interest rates rise. This can result in a higher loan balance over time. Verify the adjustable rate mortgages you are considering do not have any negative amortization.

The Rewards

Lower Initial Rates: Variable rate mortgages often start with lower interest rates compared to fixed-rate mortgages. This can lead to lower initial monthly payments, making homeownership more accessible.

Potential Interest Savings: If interest rates remain stable or decrease over time, borrowers with variable interest rates can benefit from lower overall interest costs compared to fixed-rate mortgage borrowers.

Short-Term Solution: Adjustable rate mortgage ARM terms may be suitable for borrowers who plan to move or refinance within a few years, before the rate adjustments begin.

Rate Caps and Limits: Many variable rate mortgages come with interest rate caps and limits that protect borrowers from extreme rate increases. Understanding the terms and limits in your loan agreement is essential to assess your risk.

Fixed-Interest Rate vs. Adjustable-Rate Mortgages

Fixed-rate mortgages and adjustable-rate mortgages (ARMs) are the two primary types of mortgages, each with distinct interest rate structures. Fixed-rate mortgages feature an interest rate that stays constant for the duration of the loan, whereas ARM loans have interest rates that can fluctuate in response to broader market conditions. Explore the differences between fixed-rate and adjustable-rate mortgages, including the advantages and disadvantages of each.

Adjustable-Rate Mortgages

The interest rate on an adjustable-rate mortgage (ARM) is variable, typically starting lower than that of a comparable fixed-rate loan. Over time, this rate may increase or decrease based on prevailing interest rate trends. Eventually, the rate on an ARM might exceed that of a fixed-rate mortgage.

ARM loans feature a set period during which the initial rate is fixed. After this period, the rate adjusts at predetermined intervals, which can range from as short as one month to as long as 10 years. Generally, shorter adjustment periods are associated with lower initial rates.

Fixed Mortgages

Borrowers that opt for fixed interest rates usually like the peace of mind and protection against the Federal Reserve Bank raising key rates. With a fixed-rate mortgage, you are guaranteed the same monthly payment for the duration of the term. That means the lender or bank cannot raise your interest rate even when the Fed hikes rates.

Important Points

A fixed-rate mortgage features an interest rate that remains constant over the life of the loan. In contrast, the interest rates on adjustable-rate mortgages (ARMs) can fluctuate, rising or falling in line with broader interest rate movements. Initially, ARMs often offer rates that are lower than those of comparable fixed-rate mortgages. However, ARMs tend to be more complex than fixed-rate mortgages due to their variable nature.

When to Consider a ARM Mortgage Loan?

Adjustable rate mortgages are not for everyone, and they involve certain risks. However, there are situations where ARM loans can be a suitable choice:

Short-Term Ownership: If you plan to own the property for a short period, a adjustable rate mortgage with a fixed-rate period can offer lower initial payments without the long-term risk of rising rates.

Lower Initial Costs: If you need a more affordable initial monthly payment and expect stable or declining interest rates, an ARM mortgage can provide lower costs in the early years.

Risk Tolerance: Borrowers with a higher risk tolerance may be comfortable with the uncertainty of variable rate mortgages, provided they have the financial flexibility to handle rate increases.

Rate Caps: Choosing a variable rate mortgage with well-defined interest rate caps can mitigate the risk of excessive rate increases.

What Is the Secured Overnight Financing Rate?

The Secured Overnight Financing Rate, or SOFR, represents a comprehensive gauge of the overnight borrowing costs when secured by Treasury securities. It is determined directly from transaction data within the U.S. Treasury repurchase market.

What Is an Adjustable Rate Mortgage or ARM and Should I Refinance Out of It?

An ARM or adjustable-rate mortgage has a fixed, lower introductory rate for 3, 5 or 7 years usually, and then resets to market rates.

This is different than a 30 year fixed rate mortgage that has the same rate for the entire term of the loan.

Why should you consider getting an ARM if you are buying a home or refinancing in 2024?

Here are the best reasons to consider mortgage-refinancing loans with variable interest rates:

#1 Interest Rates Are Rising

The major reason that people get an ARM mortgage is that they usually will pay 1/2 a point to a full point lower interest rate than they will with a fixed rate. This will mean substantial savings on your mortgage payment every month. If the Federal Reserve follows through on promises and increases interest rates at the end of this year, this means that most mortgages could see lower interest rates in 2024. But if you get an ARM, you will certainly enjoy a lower interest rate than you will with a fixed-rate mortgage. Getting an ARM is a way to avoid the full brunt of higher interest rates in 2024 and beyond.

#2 Going from a Fixed Rate to ARM Mortgage Can Save You Big

If you are thinking about refinancing and you have a fixed-rate mortgage, you may be able to save a lot of money by refinancing into an ARM. Let’s say that you got a fixed-rate mortgage in 2023; you could easily be paying well above 6%. Even if mortgage rates rise in 2024, you could well refinance into a five or seven-year arm that is well below 6%. Imagine saving more than $100 per month on your mortgage payment! That is what you might be able to do by going from an old fixed-rate mortgage to a new ARM! Verify current refinance mortgage rates before making any plans.

#3 If You Are Pulling Out Cash, Your Rate Will Still Be Lower

If you are refinancing and are taking out equity, you will pay a lower interest rate on the money you are pulling out with an adjustable-rate mortgage. If you are taking that money and putting it into an investment, this will allow you to enjoy a higher investment yield.

#4 Potentially, You Could Save Money During the Introductory Period

Many older home buyers and owners think that getting a fixed-rate mortgage is always the best thing to do because of the ‘security’ of a fixed rate. However, this is, according to many experts, rather outdated thinking. The fact is that many Americans today choose an ARM mortgage when they are buying or refinancing. You can save the money that you would have paid for the higher interest rate of a fixed mortgage and put it into an interest-earning investment. What closing costs are deductible when refinancing?

#5 The ‘Security’ of a Fixed Rate Is Often an Illusion

It is true that a fixed-rate mortgage will provide you with a fixed rate over the entire term of your loan. The problem is that many people do not stay in the home long enough to ever justify getting a fixed rate. Most of us will move out of their current home within 10 years. Few people stay in a home for a full 30 years these days.

Further, most people will refinance their mortgage within five or seven years. It is very rare today for homeowners to hold the same mortgage for 15 years or more. So, if you are not really going to be using the ‘security’ of a fixed-rate mortgage, what is the point of having a higher rate?

#6 ARM Rates Have Caps

Virtually any ARM loan that you can buy today in the United States has a cap for the rate. It is very rare that the rate can ever go higher than three or four points more than the ARM introductory period. So, when you refinance your ARM, you will know what the worst-case scenario is for your loan when the introductory period ends. If you don’t think that you would be able to handle the worst-case scenario payments, then you should probably not get an ARM. The reality is that not everyone is a good candidate for adjustable rate refinancing. Check the Today’s 3/1 and 5/1 ARM rates.

Perspective on Refinancing with an ARM Mortgages

Getting an ARM when you refinance or buy a new home makes great sense for many Americans these days. You are going to make lower payments and will be able to take the saved money and do something to turn a profit. And with interest rates on the way up, you will definitely save yourself considerable money every month by going with the lower adjustable rate.

Adjustable rate mortgage loans provide a risk-reward dynamic that appeals to certain borrowers. ARM loans offer lower initial interest rates and the potential for long-term interest savings. However, these advantages come with the risk of interest rate fluctuations and higher payments.

Borrowers considering adjustable rate mortgages should carefully evaluate their financial situation, risk tolerance, and long-term homeownership plans. It’s advisable to work with a knowledgeable lender or mortgage professional who can provide guidance, explain the terms and conditions, and help borrowers make informed decisions based on their unique circumstances. Ultimately, the suitability of a variable rate mortgage depends on individual financial goals and the ability to manage potential rate adjustments.

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