Adjustable rate mortgages earned a pretty nasty reputation during the Great Recession and for good reason: a lot of people gambled with loans they ultimately couldn’t afford, and there were negative outcomes across the board.
Those days are behind us, but a lot of myths still remain about adjustable rate mortgages (ARMs). If you’re considering one of these specialized mortgages, it’s important to know the pros and cons.
First, let’s get some definitions straight. An adjustable rate mortgage is a home loan that starts out at a certain interest rate for a certain number of months or years. After that introductory fixed period, the rate is subject to change based on financial indexes plus lender margins.
When you’re comparing ARMs, the first number in the loan type refers to the length of the fixed period. The second number refers to the frequency with which the rate will adjust once the fixed period is over. For example, a 5/1 ARM means the rate will be fixed for five years and then adjust each year thereafter. A 7/1 ARM means the rate will stay the same for seven years with a one-year adjustment schedule after that, and a 5/6-month ARM means you’ll get five years on a fixed rate with a six-month adjustment schedule.
Your Castle & Cooke Mortgage loan officer will be able to tell you which ARMs you’re most likely to qualify for and help you crunch the numbers to determine if they’re a suitable option.
Situations where an ARM may make sense
Deciding whether to get an ARM depends on your financial situation, your future plans, and your appetite for risk. The decision is ultimately up to you, but there are some instances where they may make sense:
- You’re only planning to keep the home for a few years
- You’re planning to pay off your loan before the adjustment period starts
- You don’t have a large down payment now, but plan to grow your equity and refinance within a short timeframe
- Rates on home loans are high, and you expect them to decrease in the future
Times when homeowners should be cautious
The risk of not knowing what your future payments will be is real, and it makes sense that most homeowners opt for fixed rate loans on what could be the biggest purchase of their lives.
An ARM might not be right for you if:
- You’re buying your family’s forever home
- Mortgage rates are already near record lows
- You’re uncertain how your income might change in the future
Pros and cons of an adjustable rate mortgage
While you’re considering your options, it helps to be clear on the benefits and potential costs of an ARM.
Flexibility: If you’re moving in a few years and just need a mortgage to get you through grad school or a lucrative contract job, an ARM might be a good way to save on interest.
Faster equity growth: Because ARMs start off at a lower rate than most fixed rate loans, a bigger percentage of your payments in the first few years will go toward principal. That means more equity growth early on.
Lower rates in the future: If financial indexes change and rates fall in the future, the interest rate on your ARM could drop.
Unpredictable payments: With a fixed rate mortgage, your monthly payment will stay pretty much the same for the life of the loan (with minor adjustments based on local property taxes and homeowner’s insurance). With an ARM, your monthly payment could double (or more) when the adjustment period starts.
Refinance costs: While you may hope to refinance a few years after securing an ARM, no one can be certain that a refi will be an option when the time comes. If you do qualify, keep in mind that you will need to pay another round of closing costs (which total 2%-5% of loan value). You'll also need to keep a great credit rating, keep your other debts in check, and have the income to support a new loan.
Housing market unknowns: If home prices in your area decrease and you simultaneously have a big increase in payments, you could be stuck between a rock and a hard place: you might be unable to make payments and unable to sell or refinance.
Future income risk: While you may have a great job or big plans for a lucrative career, there’s no way to know what the future will hold. Disaster may strike, your industry could face disruption, or you could face medical challenges that disrupt your plans. We hope this doesn’t happen to you, but the risk is worth a moment of contemplation.
Adjustable rate mortgage FYI
Rules set by the Consumer Financial Protection Bureau (CFPB) require all lenders to provide a standardized form known as a Loan Estimate as part of the mortgage application process. This document is a great place to find out more about the fixed and potential costs of any home loan, including an adjustable rate mortgage.
Look for these sections to determine whether an ARM makes sense for you:
Loan terms: This section will tell you whether your loan comes with a balloon payment or prepayment penalty. If the answer in either of these boxes is YES, make sure you understand the potential ramifications.
Projected payments: This section will give you info on monthly payments, including maximums and minimums for the life of the loan. If you see something you don't understand, we recommend asking your loan officer how rate caps work for the loan you're considering.
Annual percentage rate (APR): This field, on the final page of your estimate, tells you the total costs to borrow money over the loan term. Use this to compare different loan products and offers from different lenders.
The CFPB also publishes a booklet on the risks and benefits of ARMs, and you should receive a copy from your loan officer if you're considering this kind of loan.
Contact your loan officer
When you’re ready to find a mortgage that’s a great fit for your family, your finances, and your future, your Castle & Cooke Mortgage loan officer will guide you through your options and answer all your questions.
Whether you’ve already found a home you love or just want to start planning for the future, get in touch!