An adjustable rate mortgage, or ARM, is a home loan that offers an initial period of a fixed interest rate for home buyers. After a certain amount of time, usually 3 years or 5 years, the rate of the mortgage adjusts to the current interest rate offered in the market. That means the mortgage rate could decrease, or it could rise dramatically.
There is a certain amount of risk associated with the decision to pursue an adjustable rate mortgage. It is rarely a good long-term mortgage option, though for homeowners that plan to move within a few years of purchasing their home, it could be advantageous.
That is why it is necessary to evaluate these adjustable rate mortgage pros and cons before finalizing a decision on which mortgage type to pursue.
List of the Pros of an Adjustable Rate Mortgage
1. They offer more flexibility than other mortgages.
If you know that your life is going to change within the next few years, then an ARM makes a lot of sense. Maybe you know that you’ll be moving and will need to sell the house. Perhaps you know that a financial settlement or change in your income will be happening. In those situations, you can take advantage of the fixed-rate period for the adjustable rate mortgage and then sell before the adjustable phase of this loan begins.
2. The payments for the fixed-rate phase are typically low.
Many fixed-rate ARMs, including hybrid mortgages, offer buyers a prolonged period of a low fixed payment. That means the initial mortgage payments during the fixed-rate period could be lower than a long-term, fixed-rate mortgage of 15 years or 30 years. An introductory interest rate might be offered as well, which could be lower than the current interest rates for new mortgages. That means your payments will be predictable for a specific time period.
3. There are several types of caps available for ARMs.
You can negotiate specific caps into your adjustable rate mortgage contract to limit the liabilities you face during an adjustment period. Interest-rate caps tend to be the most popular as they limit how much the rate can change each time it adjusts. A lifetime interest-rate cap can be included within the contract each time. You can have payment caps too, which would limit how much the mortgage could grow during each adjustment period.
Each cap offers certain benefits and risks, which should be personally discussed with your lender of choice.
4. Your mortgage payments could become smaller.
Much of the talk surrounding adjustable rate mortgages is about what happens when interest rates rise. That means your mortgage rate rises too if the interest rates increase during your adjustment period. The opposite is also possible. If the prevailing interest rate happens to decrease, then your monthly payment could decrease as well. It all depends upon how the index where your ARM is benchmarked performs.
5. Lifetime caps can limit overall responsibility.
Most ARM loans come with a 2/2/5 cap. That number means the initial rate adjustment is a maximum of 2% due to the interest rate rising. The second number is how much the maximum adjustment can be with each subsequent period. It reflects upward and downward interest rate changes. The final number is the maximum adjustment possible over the lifetime of the loan, which would be 5%. That means if you have an initial rate of 4.2%, your interest rate can never be higher than 9.2%.
List of the Cons of an Adjustable Rate Mortgage
1. After the initial period, the mortgage rate adjusts annually.
There are 4 different types of ARMs available. You can have an initial period of 3 years, 5 years, 7 years, or 10 years. Once this initial period expires, the interest rate for the mortgage will adjust annually to the current interest rate. The actual adjustment periods are written into the mortgage contract and are negotiable, so no two ARMs are exactly alike. From a general perspective, however, a 3/1 ARM would mean 3 years at a fixed interest rate, then 27 annual adjustments.
2. They are a complex lending product.
ARMs are much more complex than a traditional fixed-rate mortgage. The rules can be somewhat complicated, especially if the mortgage terms fall outside of the standardized structure. Even the fee structures can sometimes be difficult to understand. For home buyers, the appeal of an ARM is that the initial upfront costs of purchasing a home tend to be lower. The actual structure of the mortgage, however, can create risks for some borrowers who may not fully understand what will be required of them.
3. There could be a pre-payment penalty.
Some adjustable rate mortgages come with a pre-payment penalty as part of the contract. That means you can be charged a specific fee if you happen to sell your home or refinance your loan within a specific time period. As a general rule of thumb, if you intend to sell your home within 5 years of moving into it, you’ll want to talk to your lender about removing any pre-payment stipulations from the mortgage, so you’re not stuck paying a hefty unexpected penalty.
4. Refinancing may not be available.
Even with careful planning, unexpected economic events can dramatically change the interest landscape for homeowners. A jump in interest rates can translate to a mortgage increase of several hundred dollars on some adjustable rate mortgages. That can put the cost of paying the mortgage out of reach for some homeowners. Refinancing to a different mortgage may not be a possibility if things don’t go as planned, which means if you can’t make the higher payments, you will be at-risk of foreclosure in the future.
5. Your payments can get bigger… much bigger.
When interest rates are rising, your mortgage payment will increase with them when you’re on an ARM. Mortgage interest rates are somewhat stable, so dramatic increases are unlikely. They are, however, still possible. If buyers choose this type of mortgage for their home, then they must budget for the worst-case scenario during the adjustment periods to ensure they will still be able to make the necessary payments that come due each month.
6. Not all caps for ARMs are created equally.
Just because you have a payment cap or interest-rate cap on your adjustable rate mortgage does not mean you have an insurance policy against an unaffordable future payment. The first adjustments permitted by a cap could be as high as 5% for some buyers. Then future caps might be set at 1%. That can be a hefty swing, especially if it occurs within the interest rate portion of the mortgage.
7. It can lead some buyers toward negative amortization.
Having payment caps and interest-rate caps in place can provide buyers with a certain layer of protection against a wild swing in their monthly required payments. If your mortgage has a payment limit, regardless of what the interest rate may be, then it is possible to fall into negative amortization. That means your mortgage would increase, even though you’re making monthly payments, because you are not paying off the accumulated interest on your loan with the capped payment.
8. Rates and payments can still rise, despite caps.
Let’s say you’ve got a 5/1 ARM and this is your first adjustment period. Now let’s say interest rates have risen by 4% since you first signed on the dotted line. Your mortgage includes a 2% maximum first year cap, then a 1% cap for each additional adjustment period that happens annually. On your first adjustment, you’ll receive the full 2% adjustment. Now let’s say that rates remain stable over the next 24 months. Because the increase was 4%, you’ll still see a 1% interest rate increase each year.
9. You are the one assuming most of the risk.
Most lenders and banks reward buyers who want to take on an adjustable rate mortgage because it is the buyer, not the bank, who assumes most of the risk. With an ARM, buyers take on the risk that interest rates will rise. With a fixed-rate mortgage, that risk shifts to the bank. After all, if interest rates fall and you’ve got a fixed-rate mortgage, there is a good chance you could refinance that mortgage. The same cannot always be said of an ARM.
These adjustable rate mortgage pros and cons must be carefully considered when looking at your mortgage options. There are distinct advantages for some buyers that make it a viable loan option. There are distinct disadvantages that must be evaluated as well since an unaffordable higher payment could drive some homeowners toward foreclosure and a lengthy reduction in their creditworthiness.
Blog Post Author Credentials
Louise Gaille is the author of this post. She received her B.A. in Economics from the University of Washington. In addition to being a seasoned writer, Louise has almost a decade of experience in Banking and Finance. If you have any suggestions on how to make this post better, then go here to contact our team.