|Do Adjustable-Rate Mortgages Make Sense Now?
Adjustable-rate mortgages (ARMs) get bad press. The poster child for irresponsible borrowing, they’re the mortgage industry’s bad boys. But ARMs can be excellent loans for thrifty borrowers.
How ARMs work
An ARM begins with a low introductory rate that remains fixed for a specified period. Upon expiration, the interest rate periodically adjusts based on an underlying index, which goes up or down. This contrasts sharply with a fixed-rate mortgage (FRM), where the monthly payment remains consistent.
The chief advantage of an ARM is that it allows you to save money in the early years. However, it can become dangerous because historically, declining rates don’t last more than approximately five years. Therefore, payments on a 15- or 30-year ARM will generally increase over time. A plan to refinance when the introductory period ends is a terrific idea—if you can pull it off. But if you can’t, and are unable to make increased monthly payments, you may lose your home.
This unpredictability makes an ARM inherently riskier than its fixed-rate counterpart. With mortgage rates at 7.5% or less for 185 of the past 210 years, it’s a reasonable risk—except if you’re living through a period like the late 1970s and early 1980s, when interest rates hit 17%.
Is an ARM right for you today?
An ARM may be right if:
1. You plan to refinance or sell within five to seven years.
Since an ARM’s introductory interest rate is lower than its fixed-rate counterpart, you’ll save money during the loan’s first few years. The most common ARMs are 3/1, 5/1, and 7/1. The first digit indicates the number of years the introductory rate remains fixed; the second, the frequency of rate adjustments. (A 3/1 ARM has a fixed rate for three years, then adjusts annually.) If you pay off your loan, refinance, or sell before the introductory rate expires, an ARM makes sense.
Example: You borrow $300,000 to buy an investment property that you’ll fix up and resell within two years. Your options are either a 3/1 ARM that opens at 3.5% or an FRM that’s locked in at 5.5%. The ARM’s monthly payment during the first three years: $1,347.13; the FRM’s payment: $1,703.37. During the ARM’s introductory period, you’d save $356.24 monthly (about $4,275 annually). During the first two years, the aggregate savings would be about $8,550—a sizeable sum.
2. You want to pay as little as possible.
Money saved on a mortgage payment is money in your pocket. If you don’t want to pay any more than is absolutely necessary in the early years, you’re a good ARM candidate. You’ll generally save money over a 30-year fixed loan for the first seven or eight years.