There are just two reasons to take out an adjustable-rate mortgage
Adjustable-rate mortgages aren’t popular today, and for good reason.
When fixed-rate loans are nearly as cheap as they've ever been, there's little incentive for most homeowners to grab an ARM when refinancing.
Indeed, a recent Freddie Mac survey showed that 95% of refinancing borrowers chose fixed-rate home loans in the second quarter of 2012.
An ARM is a good option when interest rates are high.
"In the 1980s, adjustable rates were an affordable alternative to fixed interest rates of 18%," says Greg Cook, a first-time home buyer specialist at Guild Mortgage in Temecula, Calif.
But few people need an alternative to a 3.9% interest rate, which is about what the average 30-year, fixed-rate loan goes for today.
Take out a fixed-rate loan now, and you may never have to worry about refinancing again. Take out an ARM, and you'll almost certainly deal with interest-rate shock when the loan's introductory period expires.
There are just two good reasons to take out an ARM right now:
Reason 1. You will sell your home within a few years.
If you plan to retire in several years and sell your home, you might consider opting for an ARM and using the savings to fund your retirement accounts or to help your children make a down payment on their own homes.
Reason 2. You need to finance a large home loan.
Adjustable-rate loans are popular among people with high-balance mortgages (usually more than $1 million) because the homeowner can save a bundle of money during the introductory period, says Lyle J. Katz, a senior loan officer with Evolve Bank & Trust in East Setauket, N.Y.
If you count yourself among these two groups, here's what you need to know.
The most common type of ARM is a 5/1 ARM. The first number means the interest rate is fixed for the first five years of the loan. The second number means the interest rate changes once a year thereafter for the life of the loan.
The adjustable rate depends on market conditions. It cannot fall lower than a stated amount, called a floor, or rise higher than a stated amount, called an interest rate cap.
This type of ARM, also called a hybrid ARM, could have a shorter or longer fixed-rate period, such as three years or 10 years. It could also have an interest rate that resets more or less often than once a year.
Based on today’s average interest rates, choosing a 5/1 ARM instead of a 30-year, fixed-rate loan will save you $56 a month for every $100,000 borrowed. Choosing an ARM instead of a 15-year mortgage would mean a monthly savings of $280 per $100,000 borrowed. (The monthly payment is higher because the payoff time is half as long.)
During the five-year introductory period, a 5/1 ARM could save you more than $3,300 compared to a 30-year fixed, or nearly $17,000 compared to a 15-year fixed.
You can search for the best ARM rates in your area from our database of lenders.
Our adjustable-rate mortgage calculator will help you figure out the monthly payment based on the loan amount and interest rate you secure.
There might be a psychological benefit to having an interest rate that begins with a "2," as average ARMs sell for 2.90%.
"But as attractive as these rates may appear today, particularly because the market's been so stable and low for so long, they have the potential to move up very quickly when things change," says Mitchell D. Weiss, a professor in the University of Hartford’s Barney School of Business.
All the risk of an ARM falls on the consumer with today’s low interest rates.
Future interest rates will most likely be higher, increasing the monthly payments on this type of loan. You put yourself at risk if you cannot sell, refinance or afford the higher payments.
When considering an ARM, Weiss recommends you understand:
- The index against which the adjustable-rate loan is pegged. The most common indices include the London Interbank Offered Rate (LIBOR), the one-year constant-maturity Treasury (CMT) and the Cost of Funds Index (COFI). In particular, get a sense for how volatile it is relative to other interest rate indices.
- How frequently your monthly payment might change and by how much.
- How high or low the payment can go throughout the life of the loan so that you can properly budget for the changes.
If you don’t think you could afford a higher payment — even if you plan to move within a few years or have a large loan balance — opt for the fixed-rate loan.
It's a safer bet for you.