Understanding the Pros & Cons of Adjustable Rate Mortgages Roger Odoardi Reviewed by: Jason Caruso Buying a first house is an exciting and nerve-wracking process. Not only are you picking the place to call home for life’s next chapter, but it’s also one of the biggest and most financially burdensome undertakings most people experience. Very few individuals or families have the money to purchase a house or condominium outright, which is why most homeowners end up with some type of mortgage. In fact, residential mortgage debt in the U.S. totaled $11.92 trillion in 2022. While most mortgages are fixed-rate mortgages, which feature an unchanging interest rate over a set period of time, adjustable-rate mortgages (ARMs) also make up a significant portion of the residential market. Many associate ARMs with the subprime mortgage crisis of the late 2000s. However, as the name makes clear, most of the mortgages that went underwater were subprime mortgages, meaning they were taken out by people with poor credit who often put little to nothing down. Many were also option ARMs, which allowed for negative amortization, further compounding the issue. In this blog post, we’ll discuss what an ARM mortgage is, go over adjustable-rate mortgage pros and cons and share suggestions to help you get the most out of your mortgage. What is an Adjustable Rate Mortgage? As the name suggests, ARMs feature an interest rate that can go up or down over the life of the loan. Today, most ARMs are hybrids, featuring an initial fixed period or teaser rate, typically for anywhere from one to five years, followed by a period where the rate can fluctuate according to market conditions as measured by a major index. These indexes, such as the 11th District Cost of Funds Index, are independent assessments of the economy’s performance. Typically speaking, when times are good, they go down, and when times are tough, they rise. To mitigate rapid changes in the marketplace, hybrid ARMs typically feature caps that limit how much your rate can change over a given period of time. Caps also apply during the initial adjustment, every time a period ends and over the course of the loan’s lifetime. The caps and period lengths will be in your initial loan documents. Adjustable-rate mortgage examples of this structure are 3/1 ARMs where the first adjustment takes place three years after the loan is taken out, with further adjustments annually, and 5/6 ARMs with an initial adjustment after five years and further changes possible every six months. The first number represents when the initial adjustment occurs with the second number specifying the periods at which future adjustments can occur. It is important to note that when the second number is six, it means six months. All other numbers represent years. Adjustable-Rate Mortgage Pros When you ask many people for adjustable-rate mortgage pros and cons, they’ll immediately start talking about the subprime crisis and tell you to steer clear. However, today’s hybrid ARMs have advantages that simply weren’t present back then, adding considerably more weight to the pro side. General Pros Lower Initial Interest Rates Adjustable rate mortgages typically come with lower initial interest rates than their fixed-term counterparts because the adjustable rate fluctuates with the market, helping the lender hedge against a future rise in interest rates. Lower Monthly Payments Along with the lower starting payments, there is always the possibility that your payment could drop in the future. This increases your time value of money and potential overall expenditure. Greater Affordability or Buying Power With lower interest rates and monthly payments present, your buying power increases. This can be used to purchase a more expensive residence or help bring the overall cost down. More Flexibility The lower initial payments afforded by an ARM allow for greater flexibility to adapt to changing circumstances that may arise in the future. This is particularly true of adjustable-rate mortgages with longer initial rate periods. Pay the Principal Down Faster Lower starting interest rates create a situation where more of each payment goes to the principal. Extra funds can also be applied toward the principal to decrease the number of future payments. Situational Pros Home is a Short-Term Investment If you only plan on owning your home for a short amount of time, an ARM could be right for you due to the lower initial interest rate. This will save you money without the risk of an upward adjustment as you’ll likely be selling your residence before one can occur. You Plan on Paying the Home Off Quickly Similarly, the lower starting interest rate is beneficial if you plan on paying off your home before the fixed-term ends. The lower payments will free up more money to pay off the principal in advance, decreasing the overall cost of ownership. Projected Greater Payment Ability After the Fixed Term Ends While there is some risk associated with the fixed-term ending, this can be mitigated if you foresee having a greater ability to pay by the time it does. Future promotions, inheritance or other forms of cash influx can make an ARM a great option. Projected Holding or Lowering of the Current Index Rate ARMs can end up being even cheaper than fixed-rate mortgages after the initial period if the index rate holds or lowers. This would make your effective rate at or below the initial one, which should have started lower than fixed-rate alternatives. Plan to Refinance Before the Fixed Rate Period Ends Refinancing your home is always an option. If you refinance before the starting period ends, you avoid the cost of any potential increase in interest rate, thus saving you money. Adjustable-Rate Mortgage Cons While the pros can be persuasive, there are cons that must be considered as well. For people in certain situations, these disadvantages should be dispositive. Others might not find them so. Regardless, it’s important that everyone keep these cons in mind when considering ARMs. General Cons Uncertainty About Future Interest Rate Changes This is the big one that informs the others. Once the fixed period ends, rates can adjust upward. This level of uncertainty can make more risk-averse buyers understandably cautious. Possibility of Higher Monthly Payments Many people max themselves financially when taking out a mortgage. If interest rates adjust upward, then you might end up with higher monthly payments. This creates undue stress for the borrower and can potentially lead to default. Situational Cons An Upward Adjustment Would Put You in a Position Where You Can’t Make Your Payments If an upward change in the interest rate would lead to you defaulting, then there should be serious thought given as to whether an ARM is really right for you. Losing a home can be a traumatic event, and any risk of that occurring should not be taken lightly. Projected Increase in the Index Rate Even if you can afford to weather an upward adjustment, it can still turn your adjustable-rate mortgage into the costlier alternative when compared to a fixed-rate one. If there is sufficient evidence that the index rate will rise, an ARM may not be the best choice. You Plan to Stay in Your Home for a Long Time The longer the period of your mortgage, the greater the risk that the index rate will rise during its lifetime due to natural fluctuations in the market and unpredicted events. If you plan on staying in your home for 30 years, for example, then a fixed-rate option may be better for you. Steps to Maximize Your Mortgage Now that you’ve seen some of the benefits of an adjustable-rate mortgage, as well as the downsides, the natural next question is how to go about getting one. When it comes to getting your ideal mortgage, there are some best practices everyone should follow. Decide Whether an Adjustable or Fixed Mortgage is Best for You If you’re risk averse, there is a predicted increase in the index rates or an upward payment would cause financial strain, then it would probably be best to stick to a fixed-term mortgage. However, if there’s a good chance rates will remain constant or decrease, and you can afford an upward adjustment, there are many reasons to consider an adjustable-rate mortgage. Decide What Type of Adjustable Mortgage Is Best For You There is considerable variation in the types of ARMs available today. Different combinations of initial period and repayment period lengths are best suited for different types of borrowers. Furthermore, the caps on offer can also affect suitability. Research Multiple Lenders Like the different types of adjustable-rate mortgages, ARM lenders can be very different from each other. Make sure to pay attention to their reputations, as well as the specific terms each lender offers. Reach out to multiple financial institutions to gather this information before making an informed decision. Monitor Index Rates Once you have chosen a provider and signed the loan documents, you may think you’re done. However, if you’ve chosen an ARM, it is important to monitor the appropriate index rate when your initial period is almost done so you can plan accordingly. Keep an Eye on Refinance Opportunities Prevalent interest rates on offer can vary greatly over time. Increases in your associated index or lowering of refinance rates can make the idea of refinancing attractive. That’s why it’s important to be aware of what’s out there, as there are often ways to lower your payment. Even if you started out unsure about what an ARM mortgage is, you now have a solid grasp of its benefits and potential risks that come with adjustable-rate mortgages. Finding the right partner to help you through the mortgage process can prove invaluable. Blue Water Mortgage proudly serves NH, MA, ME, VT, CT, RI, NC, CO, TX and FL’s mortgage needs, offering a range of adjustable and fixed-rate mortgages along with impeccable customer service. Have questions? Download our Mortgage FAQs eBook to get more great information or feel free to contact us if you prefer. Roger Odoardi Roger is an owner and licensed Loan Officer at Blue Water Mortgage. He graduated from the University of New Hampshire’s Whittemore School of Business and has been a leader in the mortgage industry for over 20 years. Roger has personally originated over 2500 residential loans and is considered to be in the top 1% of NH Loan Officers by leading national lender United Wholesale Mortgage.