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.
3. You want to aggressively pay down your mortgage.
According to Dave Donhoff, a financial advisor at Leverage Planners in Kirkland, Wash., "An immediate ARM is good for a borrower who wants to get rid of his mortgage as quickly as possible. It's risky because rates can change monthly, but since you'd be paying significantly less than with a fixed-rate loan, you could accumulate home equity faster by aggressively paying down your mortgage."
Example: You have a 30-year FRM of $100,000 at 6%; the monthly payment is $500. An immediate ARM might be around 3%, or $200 per month, which is a 60% savings over the FRM. If you paid down your principal with that savings, you'd have $3,000 a year of accelerated equity accumulation.
Of course, it can be harder in practice. Suppose you plan to sell the property once the introductory rate expires. Your home's value could plummet, and selling wouldn't pay off your loan balance. Or the real estate market could stagnate, making it difficult to unload your home.
If you plan to refinance, a tight lending environment could make that challenging. If your home value drops, you may not have enough equity to refinance. Credit standards could change, making you a less-than-desirable borrower. Or rising interest rates could disqualify you for a new loan based on your monthly income and expenses.
These risks could derail your plans to pay off the mortgage, so evaluate what might happen after the ARM resets. Check its periodic cap; this is the maximum amount your mortgage rate can increase at each adjustment. If this cap is 2%, your 3/1 3.5% ARM could rise to 5.5% in year four, 7.5% in year five, and so on. In year five, your payment could rise to $2,023.57, which is $320.02 more than with a FRM. Assuming a rising ARM, you'd give back all your savings from earlier years in year seven.
These numbers could substantially differ depending on the periodic and lifetime caps associated with your specific ARM. A less aggressive mortgage with a lower periodic cap could take significantly longer to sour.
If your risk tolerance and flexibility levels are low, an FRM is a better loan for you. Ultimately, even though there can be cost savings with an ARM, you should choose the mortgage that gives you peace of mind in any market.