When it’s time to meet with their mortgage experts and apply for loans, most home shoppers accept mortgages with fixed interest rates. When they do, the interest rates are locked in throughout the life of their loans. That’s a good thing, of course, if interest rates are low when the buyers get their loans.
Adjustable-rate mortgages (ARMs) can seem complex and unpredictable by comparison. At its outset, the common “hybrid” adjustable-rate mortgage starts with a low, fixed teaser rate that the borrower keeps for a certain period — normally three, five, seven, or ten years. Then, it becomes adjustable.
After the initial, fixed-rate period, the payment is recalibrated based on the current interest rates and following the terms set out in the mortgage. Often this is done annually. An ARM could be written as 5/1, for example, meaning the borrower enjoys a low, fixed rate for a five-year period, and after that, mortgage payments will be adjusted every year. So, a borrower who goes to the adjustable rate has to make higher or lower monthly payments as interest rates fluctuate.
An adjustable-rate mortgage typically puts a limit (cap) on the homeowner’s payment increases. Nevertheless, there’s an element of risk in a variable rate. It’s possible that the borrower will have to make much larger monthly payments in later years.
Let’s turn to why some home buyers choose adjustable-rate loans despite this risk.
Strategic Borrowing: An Adjustable-Rate Mortgage Has Its Selling Points.
Home buyers who choose mortgages with adjustable interest rates have a variety of rationales for doing so. Here are six reasons why the ARM could be a sensible option:
1. To make the house purchase possible.
Buyers sometimes want to bid on more expensive homes then they could otherwise get. The borrower starting off with a bargain interest rate through an adjustable-rate mortgage is eligible for a bigger purchase. If the rates begin to rise later, the buyer may decide to refinance the house with a new, fixed-rate loan.
2. In anticipation of a rising income.
A buyer might need a low rate at first, while expecting to move into a good position to refinance later. This could be due to a coming rise in income, or an expected cash windfall such as money from retirement funds or even an inheritance.
3. To boost the value of real estate investments.
Interest increases the cost of buying property. For this reason, some investors employ the ARM as a strategy to lower the total interest they pay, and strengthen their real estate portfolios. These investors watch interest rates and time the refinancing of their loans. Financial planners can guide borrowers making large real estate deals to save significant amounts of money with ARMs.
4. To boost the value of financial accounts.
By obtaining lower starting rates, some buyers leverage variable-rate debt in order to pay off other debt, or build emergency funds. Or perhaps they prefer to leave more money in their retirement accounts. If their stock portfolios stop beating the mortgage rate, these owners pay off their mortgages.
5. To make lower mortgage payments in anticipation of a move.
Others might be planning a move a few years after buying. They obtain an ARM so they can make lower payments than they otherwise would have had, until the time they’re ready to move. In this situation, a 30-year, fixed-rate mortgage isn’t optimal, given that they’ll be paying so much in interest rates and gaining relatively little in equity during the first few years of a mortgage loan.
6. To get an earlier release from private mortgage insurance.
A buyer who doesn’t put 20% down has to deal with private mortgage insurance (PMI) payments along with paying the mortgage principal and interest. By taking the ARM and getting a low interest rate, this buyer might be positioned to make extra payments on the loan principal, build up 20% equity in the house quickly, and ask the lender to remove the PMI.
Still other buyers invest in property categories outside of the conventional mortgage sphere, where adjustable rates are the customary way of doing business. So, an ARM could be necessary — or it could just be strategically preferable to a fixed-interest loan. ARMs can be an option for home buyers who plan to pay off the loan in a few years — whether for strategic investing, due to an impending move, or an in anticipation of a rise in income. Your financial consultant or mortgage specialist can go over the opportunities and risks with you.
Pro tip: Some ARMs will slap on a prepayment penalty for selling or refinancing. Buyers might wish to avoid these stipulations, and should ask their mortgage experts to carefully explain the terms of any proposed loan.
Interest Rates Were Not Always This Low: Remember the 80s?
In earlier decades, interest rates were much higher than they are today. A 12.5 or 13% fixed mortgage rate was the norm back in the early 80s!
Buyers who get ARMs during times of high rates could see their monthly mortgage payments drop, as they did from the 1980s on. In this way, some borrowers have taken advantage of downward shifts into low-interest environments with no need to refinance.
Indeed, back in the late 70s and early 80s, when ARMs were introduced, fixed-rate mortgage loans were beyond the financial reach of many home buyers. By the mid-80s, rates had begun their long journey downward, until they touched down below 3% in 2020.
Now, in 2021, we’re enjoying a low-interest environment. So, the big question is this. Should a prospective homeowner go for a changeable rate when interest rates are poised to rise? Generally, the answer is no.
Could an Adjustable-Rate Mortgage Be the Right Home Loan for You?
Getting an adjustable rate today would mean having to anticipate a likely climb in interest rates — and that means rising monthly payments. But as we’ve shown, there are still at least six scenarios where the ARM could prove its strategic value.
Still, ARMs are more complex than fixed-rate mortgage loans. The way they are structured can cause plenty of questions and issues for home buyers who are not used to them, and are unprepared to handle the risks.
Say interest rates keep rising, and a hot market abruptly cools. That’s when an ARM presents challenges. In such an environment it becomes harder for buyers to refinance or sell.
What’s the worst-case scenario? The fixed “teaser rate” expires. The mortgage payment is adjusted up. The homeowner has trouble making the higher payments, and now risks losing the house.
So, could an adjustable-rate mortgage be right for you? The answer is… It’s complicated. We hope this exploration offers some insights into why that is. To really make an educated assessment, speak with a professional about your own situation, future plans, and financial goals.
U.S. Department of Housing and Urban Development (HUD): FHA Adjustable-Rate Mortgages.
Pentagon Federal Credit Union (PenFed): The Difference Between ARM and Fixed-Rate Mortgages.