The Truth About Adjustable Rate Mortgages

An adjustable-rate mortgage (ARM) is “a loan with interest rates that are adjusted periodically based on changes in a pre-selected index after a set fixed-rate period. As a result, the interest rate on your loan will rise and fall with increases and decreases in overall interest rates.”

There you have it. The official definition of an ARM.

What’s that? You still have questions? Ok, let’s start at the beginning.

What’s an Adjustable-Rate Mortgage Anyway?

First of all, an ARM is a home loan that has an interest rate that can adjust over the term of your loan, although it can only adjust up and down a set amount during your loan period. And that, of course is after the fixed-rate period (which with Quicken Loans is always 3, 5, or 7 years). You see, most ARMs come with an interest rate cap, which limits the amount by which the interest rate can change (again, both up and down). Make sure you insist on an interest rate cap when you consider an ARM. You may regret it if you don’t.

Next, you might be asking “why would I ever want an ARM as opposed to a fixed-rate mortgage? Although it’s true that ARMs do have the potential to raise your monthly payments if the rate adjusts upward, an adjustable-rate mortgage can make a big difference in lowering your monthly payments, too. The reason is simple. ARMs almost always offer a lower rate during the fixed-rate period than other loans. A lower rate means a lower payment. So, whether you’re buying your first home or refinancing, an adjustable-rate mortgage is a popular option.

Who benefits from an Adjustable Rate Mortgage?

Home buyers looking for the lowest rate and lowest possible monthly payments may benefit from an ARM, especially if you are planning on staying in your home for less than 7 years.

A great example is the first time home buyer. Let’s set the stage. Imagine a young couple, they find a cute little home and buy it. If they are typical, in just a few years they will experience job transfers, more income, and (“gulp”) growing families. That cute little home is now very little. If this same young couple pays 1% more for a fixed mortgage vs. a 5-year ARM (where the rate is fixed for 5 years), on a $200,000 mortgage, that difference means the couple will pay approximately $10,000 more over those 5 years by choosing the 30-year fixed. Yes, you read that correctly. A 10 thousand dollar difference. That ain’t chump change, my newlywed friends.

Also, keep in mind that the average person who chooses an ARM usually moves or refinances before the ARM begins to adjust. In the rare case someone holds onto the ARM past the fixed period, the built-in security features (the interest rate cap) of an ARM kick in. So if you have a 2% interest rate cap, your mortgage rate could only rise 2% above your initial fixed rate, regardless of how long you keep your mortgage.

Should You Get an ARM or a 30-Year Fixed? Consider This

When shopping for a mortgage, you must ask yourself a few questions: How long do you plan on being in the home? What are the savings you’d enjoy by taking the lower rate of the ARM vs. a 30-year fixed? If you find that you’d save $10,000 in the first 5 years by taking a 5-year ARM instead of a 30-year fixed – and you believe the likelihood of your moving in five years is high – taking the ARM makes a great deal of financial sense.

If you know for a hard fact that you won’t be moving in seven years, you’ve found your dream home and you don’t care what happens next, well, a 30-year fixed is probably your best bet.

As always, the best mortgage decisions start by working with a mortgage expert who can clearly outline the pros and cons of all of today’s mortgage programs. Go over the numbers, compare the loans, consider your situation and you’ll find the best mortgage to save you the most money.