When Does It Make Sense To Get An Adjustable Rate Mortgage?

ARM loans typically offer introductory rates that are lower than what you’d get with a standard fixed-rate mortgage. However, once the introductory period is up, your rate will be adjusted according where rates are at that time.

Some of the ARM options include the 5/6, 7/6 and 10/6. The numbers indicate the length of the introductory period and how often the rate gets adjusted after that. For example, with a 5/6 ARM, the interest rate remains fixed for the first 5 years of the loan. The second number, the “6,” tells us that the adjustment period is 6 months, meaning your rate will be adjusted once every 6 months after the first 5 years is up.

ARMs also come with caps that limit the amount your rate can increase, both during a single adjustment period and over the life of the loan. Typically, an ARM includes three different caps, shown in this format: X/X/X. The first number indicates how many percentage points your rate can increase or decrease for your first adjustment after your initial fixed period. The middle number tells you how much it can increase or decrease for each adjustment period thereafter, and the final number is the lifetime cap, which tells you the maximum number of percentage points your rate can increase or decrease overall.

So, say you have a 7/6 ARM with a 5/1/5 cap structure. After your 7-year fixed period, your rate can’t change more than 5% from the initial rate when it adjusts the first time. After that, when your rate adjusts every 6 months, it can’t be raised or lowered more than 1% at a time. Over the life of the loan, your rate can never increase or decrease more than 5% of the initial rate. For example, if your rate was 4% initially, you’ll never have a rate over 9%.

Now we’ll go over some situations where getting an ARM could potentially make more sense than a fixed-rate mortgage. Remember, though, that there’s no single factor that will determine whether an ARM makes sense for you, and you should compare all your options before making any decisions.

If It Will Save You Money

This is a big “if.” While ARMs may appear to save you lots of money at first, especially if current interest rates are high, they can end up costing more in the long run if your rate goes up after your initial rate expires.

If mortgage rates are low when you’re shopping for a mortgage, it may make more financial sense to get a fixed-rate mortgage, since you’ll be locking in that low rate for the life of the loan, instead of risking that rates go up in the years to come.

On the other hand, if rates are high, it can make more sense to go with an ARM, as that will likely save you a significant amount of money during the introductory rate period.

If You Aren’t Going To Be In The Home Long

If you sell your home before the fixed-rate period is up, you won’t have to worry about your rate increasing. If you have a job that requires you to move every few years or you’re purchasing a starter home that you know you’ll want to swap for something larger within the next 5, 7 or 10 years, an ARM could make a lot of sense for you.

A word of warning though: Plans change, homes can be hard to sell, and people sometimes end up staying put for longer than they expect. You may be absolutely sure that you’re going to be moving in 5 years’ time only to decide that you’d prefer to stay where you are. Or you might end up in a situation where you simply can’t afford to move. Or maybe you end up having bad selling luck and your house gets stuck on the market for a long time.

When considering an ARM, take some time to think about what your financial situation could look like if you end up staying in your home long enough for the introductory rate to expire.

If You Want The Financial Flexibility

Having a lower monthly housing payment gives you more budget wiggle room for other stuff, like working towards savings goals. This can be great if you’re still working on building up your emergency fund, paying off credit card debt, or if you just prefer to not have all your money tied up in illiquid assets.

Plus, also it gives you flexibility with paying off your mortgage, since you can always put extra money toward your monthly debts to pay down your loan faster.

If You’re Pretty Sure You’ll Be Able To Refinance

Often, borrowers will get an ARM with the expectation that they’ll simply refinance into a fixed-rate loan before their introductory rate resets. This is a decent strategy, provided you can actually pull it off when the time comes.

The risk of banking on refinancing is that your situation could change and prevent you from being able to do so. If your credit score drops significantly, your debt-to-income ratio goes up or your home’s value decreases, you may find that you’re ineligible for a refinance. If this happens, you’ll be stuck with the ARM and whatever rate it resets to after the fixed period.

When considering an ARM, be sure to ask your lender any and all questions you have about the loan.

In addition to the basics, like the initial rate and the rate cap structure, you should fully understand all of the terms and conditions that come with your ARM, and you should be aware of what a worst-case scenario would look like in terms of your monthly payment.

Here are some of the questions you should ask your lender:

• What’s the most I could end up paying in a given month?
• Is there a prepayment penalty?
• What is the limit for how low the interest rate can go?
• Can this loan have negative amortization?

If there’s anything else you don’t understand or aren’t sure about, be sure to bring it up. Ultimately, you want to feel comfortable with the loan option you end up choosing.