Why Choose an Adjustable Rate Mortgage?
Why Choose an Adjustable Rate Mortgage?
Understanding Adjustable Rate Mortgages (ARMs): Risks and Considerations
Adjustable rate mortgages (ARMs) are attractive to many homebuyers due to their lower initial interest rates compared to fixed-rate mortgages. However, these loans come with inherent risks that must be carefully weighed.
What is an ARM?
An ARM is a mortgage where the interest rate changes based on market conditions. After an initial fixed period, which can range from six months to five years or more, the rate adjusts periodically, typically once a year.
The Risks of ARMs
The primary risk with ARMs is the potential for significant changes in your monthly payments. With a fixed-rate mortgage, your payments remain constant throughout the loan term. In contrast, an ARM offers a lower initial interest rate in exchange for the possibility of future rate increases. As the interest rate adjusts, your monthly payment could rise significantly, impacting your financial stability.
When to Consider an ARM
Despite the risks, ARMs can be beneficial in specific scenarios:
Need for Extra Cash
A lower initial fixed rate provides more disposable income early in the loan term. For instance, a one-year ARM with a 30-year term and an initial rate of 5.625% offers lower monthly payments compared to a 30-year fixed-rate mortgage at 7.625%. On a $240,000 mortgage, the ARM payment would be $1,381.58 per month, compared to $1,698.70 for the fixed-rate loan, saving you $317 each month. This extra cash can be used to pay off debt, make home improvements, or save for retirement. However, ensure that you can afford higher payments if the rate increases.
Purchasing a More Expensive Home
The lower initial rate of an ARM allows you to qualify for a larger mortgage, enabling you to buy a more expensive home. Many buyers use ARMs with the intention of refinancing later. While this strategy can be effective, remember that refinancing comes with closing costs. Always calculate whether you are genuinely saving money.
Short-Term Homeownership
If you plan to move or upgrade within a few years, an ARM can be a smart choice. You benefit from lower payments during the initial period and can sell the home before the rate adjusts. For example, if you plan to move in three years, a five-year ARM provides a low rate that won’t adjust during your ownership. Ensure the loan has no prepayment penalties and consider future interest rate scenarios when planning your next move.
Calculating the Risks
When choosing an ARM, it’s essential to do thorough calculations and consider worst-case scenarios. Rising interest rates can lead to substantial payment increases, as seen in recent foreclosure trends where many homeowners were unprepared for their mortgage adjustments.
Evaluate Your Financial Stability: Ensure you have a budget that can handle higher payments if rates increase.
Consider Future Market Conditions: Be aware of potential rate changes and their impact on your finances.
Plan for Refinancing Costs: If refinancing is part of your strategy, factor in the associated costs.
Conclusion
ARMs offer lower initial payments in exchange for the risk of future increases. They can be beneficial in certain circumstances, such as needing extra cash, buying a more expensive home, or planning to move within a few years. However, it is crucial to understand the risks, do the math, and prepare for potential payment increases. Always weigh the benefits against the risks to make an informed decision.
