When it comes to purchasing a home, one of the most critical decisions you’ll face is choosing a mortgage that suits your needs. One that might be worth your consideration is the adjustable-rate mortgage (ARM). Yes, they received a bad rap during the housing implosion of 2008.
They’re making a comeback, however, largely due to escalating mortgage rates and high homebuyer demand.
These loans can be a boon for the buyer on a budget, but only if you’re familiar with both the pros and cons.
Let’s unpack both to help you make an informed decision.
Advantages of adjustable-rate mortgages
One of the reasons that so many homebuyers have dropped out of the real estate market is rising mortgage rates. Every tick up in interest makes a home less affordable to those on tight budgets.
One reason that ARMs are appealing to these homebuyers is that they offer a lower initial interest rate compared to fixed-rate mortgages. This is known as the initial rate, “… ranging from just 1 month to 5 years,” according to The Federal Reserve Board’s “Consumer Handbook: Adjustable-Rate Mortgages.”
This initial lower rate can make homeownership more affordable, especially for those planning to sell or refinance before the rate adjusts.
Once this initial rate expires, your rate is tied to a specific index, such as the London Interbank Offered Rate (LIBOR) or the U.S. Treasury Index.
As the index fluctuates, so does the interest rate on your ARM. The potential benefit of this is that if the index decreases, your interest rate and monthly payments could go down as well, leading to savings over the long term.
If you anticipate a change in income, plan to relocate, or expect to refinance in the near future, an adjustable-rate mortgage can provide the flexibility you need.
Disadvantages of adjustable-rate mortgages
The most significant drawback of adjustable-rate mortgages is the uncertainty and risk associated with interest rate fluctuations.
If interest rates rise, your monthly payments may increase significantly, making it challenging to budget and potentially causing financial strain.
Some adjustable-rate mortgages come with caps or limits on how much the interest rate can increase during an adjustment period or over the life of the loan.
That sounds like an advantage, and it is. But there’s a “but.” The caps may not provide enough protection if interest rates rise significantly, leaving homeowners exposed to potentially unaffordable payments.
Adjustable-rate mortgages can make long-term financial planning challenging. With the uncertainty of future interest rate changes, it’s difficult to determine precisely how much you’ll pay for your mortgage in the years ahead.
This lack of predictability can make it difficult to budget and plan for other financial goals, such as retirement or education expenses.
With typically lower initial rates, adjustable-rate mortgages may be the only way for some Americans to enter the market. However, it’s crucial to consider your financial goals, risk tolerance, and the potential impact of interest rate fluctuations.
We aren’t financial experts or mortgage specialists and urge you to contact either before deciding the type of mortgage that’s right for you.