Adjustable-Rate Mortgages: Are They Still Viable Today?

With the current economic environment, 30-year interest rates have risen from the 2.96 percent rate of 2021 to the current 6.68 percent rate.

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Buyers often gravitate to adjustable-rate mortgages (ARMs) when interest rates are high. They assume a drop is coming, and they don’t want to be locked into a high fixed rate.

But what are ARMs, and how do they work? With the current economic environment, 30-year interest rates have risen from the 2.96 percent rate of 2021 to the current rate of 6.68 percent. Can an ARM help? Who should apply for one, and what are the pros and cons?

How an ARM Works

An ARM is a type of home loan that features a variable interest rate. The initial interest rate is fixed for a period. Once the period elapses, the interest rate on the outstanding balance resets. It could increase or decrease depending on the performance of a specific benchmark.

They are often called variable or floating mortgages.

A fixed-rate mortgage comes with an interest rate that stays the same for the entirety of the loan. Therefore, your payments remain the same monthly. But with an ARM, the rate fluctuates based on market conditions. This could change your interest rate and your monthly payments.

ARMs have two distinct periods: the “initial period” and the “adjustment period.”

The “initial period,” which is also known as the fixed-rate period, lasts three, five, or 10 years.

The “adjustment period” determines when and how often the interest rate can change. Your adjusted rate will be based on your individual loan terms and the current market.

Rates are capped on ARMs. This means that there are limits as to how high your rate can go. Your credit score plays an important part in determining how much you’ll pay.

3 Types of ARMs

There are three types of ARMS: a hybrid ARM, an interest-only ARM, and a payment-option ARM.

A hybrid ARM has a mix of fixed and adjustable-rate periods. As previously discussed, you begin with a fixed rate, and then it’s adjusted.

For example, in a 30-year loan, the first two years may be fixed while the remaining 28 years have a variable rate that changes yearly. The fixed period depends on the lender.

An interest-only ARM means you pay only the interest on the mortgage for a specific time. Once the specific time expires, your monthly payment increases to pay the principal and interest on the remaining loan.

The payment-option ARM gives you multiple payment options, including the option to pay interest only, principal and interest, or even a minimum amount that doesn’t even cover interest for a specified time.

But remember that if it’s a 30-year loan, you still must pay the loan off within that period. This means that after the specified time is over, you may have an increased monthly payment for the remainder of the loan. You’ll be paying on the principal plus interest.

Pros of an ARM

The initial low rate of an ARM will save you money. You’ll have a low rate, and you may be able to put more down toward the principal. Just watch that your lender doesn’t charge you a prepayment fee.

An ARM is excellent for those who want to finance short term. It may be a starter home, or you may want to flip the house. It gives you a low payment until you sell.

With an ARM, you'll have more money in your pocket to save, invest, or make a large purchase.

In the case of rates dropping, fixed-rate borrowers need to refinance to take advantage of lower rates. But with an ARM, your rate will automatically drop when rates go down.

If rates are high and you anticipate a drop, an ARM may be beneficial.

Cons of an ARM

The biggest risk of an ARM is that interest rates may increase, thereby increasing your monthly payment. And chances are, if interest rates are increasing, the economy is bad, and you might be short on cash. An increase could blow your monthly budget.

ARMS are flexible, but they are also unpredictable. A fixed-rate borrower always knows what their monthly payment is. But an ARM borrower won’t know for the duration of the loan. You’ll need to constantly juggle your budget.

ARMS are also complicated and come with numerous features. You need to thoroughly understand what you’re signing.

Even with high interest rates, there’s no guarantee they will go down.

If your ARM doesn’t have a rate cap or the rate cap is high, you may be exposed to a significant increase.

Who Benefits From an ARM?

An ARM may be a wise financial choice for borrowers with short-term needs.

If you intend to keep the loan for a short period, because you plan on refinancing or selling quickly, you may be a good candidate for an ARM.

You may want an ARM if you anticipate an increase in your income or if you will pay off the mortgage in a short amount of time.

When Is an ARM a Bad Idea?

If you are risk-averse, an ARM may not be the type of loan for you. Retirees often avoid ARMS because they anticipate a fixed income and lack the flexibility in their monthly budget to accommodate an increase.

Those who are buying their “forever home” may also want to steer clear of an ARM because they risk a higher payment in the long term.

Are You Willing to Risk an ARM?

There are pros and cons to ARMs. For those who aren’t adverse to risk or don’t plan to stay in the house long, an ARM might make sense.

But if the thought of a high interest rate makes you nervous or you plan to keep the house for the long term, you might want to avoid an ARM.

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