Adjustable-rate mortgages make sense for the right borrowers
Adjustable-rate mortgage basics
- Adjustable-rate mortgages (ARMs) usually begin to adjust on a yearly basis after an initial fixed period.
- Popular ARMs begin to adjust after three, five, seven or 10 years.
- Homebuyers don’t always need the security of a 30-year fixed mortgage.
- Borrowers can pay significantly less on the monthly mortgage payment with an ARM.
Adjustable-rate mortgages got a bad rap during the financial crisis, some of it for good reason. Millions of borrowers took out loans with low teaser rates only to see their monthly mortgage payments shoot up when the loan rate adjusted.
Another factor that still makes many people automatically take ARMs off the table as a loan option is that people tend to like the security of a fixed-rate mortgage, particularly a loan that locks in the terms for 30 years.
During the recent period of rock-bottom mortgage rates — under 4 percent for several years — it would seem that borrowers had little incentive to look beyond a vanilla, 30-year fixed mortgage.
A case can be made for adjustable-rate mortgages, however.
First, let’s define what we are talking about.
An adjustable-rate mortgage is exactly what the name suggests: a loan where the rate will eventually move up and down. As with standard fixed-rate mortgages, adjustable-rate loans usually amortize (a fancy way of saying are repaid) over 30 years, but the rates will begin to adjust after a fixed period, usually after three, five, seven or 10 years.
With a 5/1 ARM, for example, the mortgage rate will remain fixed for five years and can then adjust, upward or downward, once a year after that initial fixed period through the remaining life of the loan.
Because variable rates push some of the risk onto the borrowers, ARMs almost always have a lower initial interest rate.
The average interest-rate difference (known as the spread) between a 30-year fixed mortgage and a new ARM, studies show, is about 0.8 percent and can be as high as 1.8 percent — in favor of the ARM. This is not always the case, however. During the early stages of the post-recession recovery, the spreads were narrow and borrowers could get little or no savings by taking out ARMs. In a normal mortgage market, however, there are usually significant monthly savings on the payments during an ARM’s initial fixed period.
Although most people like to lock in a rate for 30 years, many homebuyers won’t stay in their homes that long — particularly if it is a first home. Homeowners often move away or up to a better house, or will refinance their existing mortgages within 10 years.
Consequently, borrowers often don’t need to pay for the extra security of holding a 30-year fixed mortgage. An ARM can be especially attractive for homeowners who are likely to move because the rate can stay fixed for just as long as they need, but at a more affordable cost than a 30-year fixed instrument.
ARMs can have downsides, too. They won’t be right for every homebuyer, even though new federal regulations on the mortgage industry have stamped out some of the riskier and predatory products that got many borrowers into trouble during the last housing-market downturn.
Before signing off on a 30-year fixed-rate mortgage, a borrower should consider their financial goals and future plans carefully, and compare lenders to calculate the possible savings with an ARM.