Why Get an ARM Instead of a Fixed Rate Mortgage?

Point of Interest: ARMs vs Fixed Rate Mortgages

For many years, adjustable-rate mortgages (ARM) have earned a bad reputation because they were perceived to be riskier financing solutions than traditional fixed-rate mortgages, but what most people don’t take into consideration are the new ARM formats, which are available with extended 7- and 10-year fixed-rate terms. These extended terms give homeowners a unique opportunity to take advantage of low introductory rates while still having the possibility to lower premiums once the variable term has started.

Purchasing a new home is an exciting and monumental moment, but while shopping around for the perfect place to live can be a fun adventure, reality sets in quickly when the final costs are revealed. Thankfully, there are various financing options available for homeowners to choose from to secure the funds for their dream home.

Home loans come in all shapes and sizes, and there are plenty of options available to new home buyers regardless of their credit profile. Adjustable-rate mortgages (ARM) are a popular choice when applying for a home loan and offer a variety of benefits over other financing options, but it’s important to know what an ARM mortgage is, the benefits it provides and how it compares against conventional fixed-rate mortgages before deciding on this type of loan.

What is an ARM mortgage?

An adjustable-rate mortgage (ARM), otherwise known as a variable rate mortgage, is a loan that starts out with a fixed interest rate but switches to  fluctuating interest rates after a certain period of time. This varies greatly from a fixed-rate loan, which has the same premium amounts throughout the term length. There are options for 7-year ARM loans and 10-year ARM loans which start with a fixed-rate time frame before switching to a term that has variable rates.

Most ARM mortgages are tied to an index rate that dictates the shifting interest rates year over year. These indexes represent weekly maturity yields on one-year Treasury bills, the Cost of Funds Index (COFI) and international bank loan rates (Libor). Most lenders will provide an initial interest rate concession or promotional rate on ARM loans before relying on these index rates for premium calculations.

Although index rates can change throughout the years, many ARMs will come with caps on interest rates to protect individuals from having to pay unusually high amounts of interest over time. These caps can come in several forms and cover anything from yearly interest rate changes, lifetime rate changes and monthly payment limits, which keep your premiums affordable.

Types of ARM mortgages

7 year ARM mortgage

7 year ARM mortgages, also known as 7/1 ARM loans, are adjustable-rate mortgages that have a fixed interest rate for the first seven years of the loan. After the first seven years, rates will vary based on the index of interest rates and the pre-established caps put in place. These types of loans are best suited for individuals who might not stay in their home for more than seven to 10 years. By paying off the loan before or shortly after the fixed-term period, homeowners can see significant interest savings when compared with other loan options.

10 year ARM mortgage

10 year ARM mortgages, also known as 10/1 ARM loans, are adjustable-rate loans that have low fixed interest rates for the first 10 years the loan is active. These types of loans function like 7/1 ARM loans, but offer three extra years of fixed interest before switching to an adjustable rate.

ARM mortgage pros and cons

ARM loans are right for some types of buyers but can be a bad fit for others, so it’s important to know what the pros and cons of this type of loan are before you sign on the dotted line for your loan. These include:

Pros

  • These loans offer lower interest rates during fixed-rate periods with predictable payment schedules.
  • ARM loans often offer rate and payment caps to protect against substantial premium changes.
  • These loans help homeowners build equity faster
  • ARM loans are a great financing option when you plan on living in a home for a short period of time.

Cons

  • Some ARMs come with prepayment penalties that will cost you if you try to pay off your mortgage early.
  • These loans have inconsistent monthly payments after the fixed-rate portion of the loan.
  • ARM loan contracts are more complex and sometimes have confusing variables to consider.

Why get an ARM mortgage instead of a fixed-rate mortgage?

Fixed-rate mortgages have no variable interest rate over time and instead maintain the same rates throughout the entire term length, which leads many people to feel like fixed-rate mortgages are the better choice since they have more predictable monthly premiums. However, there are several misconceptions about ARM mortgages, making them appear riskier than fixed-term loans even though ARM mortgages can actually be an excellent option for some buyers.

One of the primary benefits of using an ARM mortgage over a fixed-rate mortgage is that ARMs have lower interest rates during fixed periods. Adjustable-rate mortgages also allow the homeowner to build equity faster than those using fixed-rate formats.

Another important consideration when comparing ARM mortgages to fixed-rate loans has to do with the fluctuations of the indexes used to calculate premiums. If rates go down year after year, fixed-rate mortgages will not allow you to take advantage of those savings and you’ll continue to pay the amount of interest you initially agreed to. ARM mortgages, on the other hand, allow you to take advantage of positive index shifts and reduce your interest rate when applicable.

It’s hard to justify choosing a fixed-rate loan over an ARM if you’re planning to stay in your home for less than 10 years. Fixed-rate loans can have you paying thousands of dollars more in interest when compared low-interest ARM rates during that same period.

The bottom line

ARM mortgages are a great way to build equity early on as a homeowner and offer more flexibility than fixed-rate loans. The lower interest rates help individuals qualify for financing on more expensive properties and give homeowners the ability to reduce their payments over time as interest rates fluctuate.