Pros and Cons of Adjustable-Rate Mortgages

By Chip Poli, Founder and CEO of Poli Mortgage

Every home purchase is different, and every homebuyer has different mortgage needs based on his or her personal financial picture.  If you’re shopping around for a mortgage loan, one of the considerations that you will want to address with your loan officer is whether to choose a fixed-rate or adjustable-rate mortgage (often referred to as an ARM). There are benefits and drawbacks to choosing an ARM, especially depending on the market at the time, so here is a quick overview of this loan type:

What is an ARM?

With an adjustable-rate mortgage, the loan’s interest rate can vary over time. This means that monthly payments can change. They can increase or decrease depending on the variable index attached to the loan and the fixed margin set by your lender. Some indices used to determine these fluctuations are the London Interbank Offered Rate, (LIBOR) the U.S. Treasury Bill (T-Bill), the Constant Maturity Treasury (CMT), and the 11 District Cost of Funds (COFI). Margins vary from lender to lender, and it pays to negotiate with your lender for a favorable margin.

How often does the interest rate on an ARM reset?

Although all mortgages are different, the interest rate on an ARM is typically static for the first few years, and then it begins to adjust, often on a yearly basis. A 5/1 ARM, for example, carries a fixed interest rate for the first five years, and then the interest rate adjusts on an annual basis going forward. Other common ARMs are 3/1, 7/1, and 10/1. As with most fixed-rate mortgages, the most common terms for ARMs are 15 and 30 years.

What are the pros of an ARM?

Most ARMs carry an attractive initial interest rate. This can be especially tempting for homebuyers who need to keep their monthly payments low and save money during the initial introductory period. For buyers who intend to sell a home in the short term – before the rate adjusts – this can be a great option for taking advantage of a low interest rate. Likewise, if a buyer has confidence that his or her income level will increase before the introductory period ends, an ARM can be a good way to save some money at the outset. And there is always the possibility that changes in the index will lead to a lower interest rate, but any borrower purchasing an ARM should prepare to see interest rates and payments rise. ARMs also carry an interest rate cap, so if a buyer feels confident that he or she can make payments at the highest rate allowed by the loan, rising payments shouldn’t be a barrier to taking on the loan.

What are the cons of an ARM?

The risk of taking on an ARM is that if your interest rate suddenly climbs steeply, you could be faced with much larger monthly mortgage payments. It’s important to have the financial cushion necessary to support these larger payments in the case that your interest rate rises. If budgeting for monthly expenses is an issue, a borrower might want to reconsider whether an ARM is a wise financial choice. ARM contracts are also typically more complex than fixed-rate mortgages because there are more variables to define. And some ARMs carry a pre-payment penalty, which could cost you if you decide to sell or refinance, so it’s important to understand all of the nuances of your particular ARM.

Whether you decide to purchase an ARM depends largely on your personal circumstances, but as with any home loan, good credit standing, stable employment, and a healthy debt-to-income ratio are all factors that will determine whether you qualify for the loan. If you’re thinking of buying a home, you should take all of these factors into account. And if you have any questions, just ask your loan officer to clarify the loan qualification process.

Call our experienced loan officers today to learn more and get a personalized rate quote: 866-353-7654.