The Pros and Cons of Adjustable Rate Mortgages

The Pros and Cons of Adjustable Rate Mortgages

Lenders know that homebuyers and homeowners have different needs, priorities and financial circumstances. That’s why, when you are looking to finance or refinance your home, you may have the option of choosing from fixed-rate and adjustable rate mortgage loan alternatives.

What is an adjustable rate mortgage?

An adjustable rate mortgage (ARM) is a loan with a variable interest rate, meaning the interest rate can fluctuate over the life of the loan. These fluctuations can cause the amount of monthly loan payments to vary over time. An ARM differs from a fixed-interest mortgage, whose interest rate and monthly payment remain constant throughout the loan term.

Some lenders, including Dollar Bank, also offer an interest-only ARM, which requires the borrower to make only interest payments (no principal) for a designated number of years. Upon expiration of that time period, payments include principal as well as interest, and the interest rate may be adjusted at the frequency specified by the loan.
  

How does an adjustable rate mortgage work?

Lenders generally charge a lower initial interest rate on an ARM than they would charge for a comparable fixed-rate mortgage, because they recognize that a borrower who chooses an ARM is taking on the risk that their loan may incur higher interest charges, and that their payments may rise, later on.

The ARM’s initial interest rate remains constant for a predetermined period of time — often five to 10 years. After that, the interest rate on the outstanding balance resets at regular intervals — every month, quarter, year, three years or five years, depending on the terms of the loan. For example, with a 5/6m ARM, the interest rate holds steady for five years and then may be adjusted every six months until the loan is paid off.

Adjustments to the interest rate may result in higher or lower payments, depending on two values that factor into that rate — the index and the margin:
 

• An index is a measure of interest rates that reflects trends in the overall economy. Lenders may use the U.S. prime rate, Constant Maturity Treasury (CMT) rate, the Cost of Funds Index (COFI) or some other index.
• The margin is an extra percentage added to the index by the lender to arrive at the interest rate that will be applied to the loan.

An interest-rate cap, a limit on how high your interest rate can go during each adjustment period, may also apply to an ARM. Nearly all ARMs have a lifetime cap, which limits the amount your rate can increase over the full term of the loan.

As you compare ARMs, be sure you understand which index each lender uses, what margin they will charge, how they will calculate your rate and the upper limit on your payments. All of this information should be included in your loan estimate as well.
  

What are the pros and cons of an ARM?

As you compare your mortgage options, here are some pros and cons of ARMs to keep in mind.

Pros:

• Potential up-front savings - Your ARM’s initial interest rate and your initial monthly payments may be lower than a comparable fixed-rate loan, saving you money in those early years.
• More buying power - An ARM may enable you to afford and qualify for a larger mortgage.
• Potential long-term savings - If interest rates hold steady or decline for a substantial stretch in the life of the loan, your loan may end up costing you less than a fixed-rate loan would have.

Cons:

• Potential higher cost - If interest rates rise during the life of your loan, you may end up paying more each month, and possibly more overall, for your mortgage loan than you would have with a fixed-rate loan.
• Unpredictable monthly payments - Budgeting can become more complicated once your initial fixed period ends, because you won’t know what your mortgage payments will be down the road.
• Defaulting on your loan - If your monthly payments rise and you can’t afford them, you may end up defaulting on the loan or even losing it to foreclosure.

Some people take out an ARM thinking that they will simply refinance their mortgage loan before their interest rate and monthly payments increase either when their initial fixed rate expires or if they see interest rates begin to rise. However, unforeseen circumstances may prevent you from doing that. For example, a job loss or medical expenses may negatively affect your financial situation, or your home’s market value may decline, so that you no longer qualify for refinancing.
  

Is an ARM right for me?

As you weigh the pros and cons relative to your borrowing needs, answering these questions may help you make that final determination as to whether an ARM may be right for you:
 

• If interest rates rise during the term of your loan, will your income be enough to cover the higher payments that result? 
• Are you expecting to take out any other loans or encounter any substantial expenses (e.g., childcare costs, medical expenses or tuition payments) in the near future? 
• How long do you plan to own this home? (If you sell during the fixed-rate period of your loan, then any interest rate increases won’t affect you.)
• Do you plan to pay this loan off early? (Again, if you pay the loan off during the fixed-rate period, rate hikes won’t affect you. Or if you make extra payments toward principal, the outstanding balance that may be subject to higher interest will be lower.)

Your lender can be a helpful resource, explaining how rates can change based on the economy, and can help walk you through what you need to know to make a well-informed decision. In addition, Dollar Bank’s adjustable rate mortgage analyzer can help you estimate how payments for various ARMs might look.

If you’d like more information about mortgage options or ARMs in particular, call Dollar Bank at 1-800-344-5626 or contact your local mortgage expert.

This article is for general information purposes only and is not intended to provide legal, tax, accounting or financial advice. Any reliance on the information herein is solely and exclusively at your own risk and you are urged to do your own independent research. To the extent information herein references an outside resource or Internet site, Dollar Bank is not responsible for information, products or services obtained from outside sources and Dollar Bank will not be liable for any damages that may result from your access to outside resources. As always, please consult your own counsel, accountant, or other advisor regarding your specific situation.