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Pros & Cons of Adjustable-Rate Mortgages
Learn the pros and cons of financing with an adjustable-rate mortgage.
Buying a home is a big, exciting step. It involves making lots of decisions, including which type of mortgage is the best fit for your current situation and financial goals. One option to consider is an adjustable-rate mortgage. We’ll explain how an adjustable-rate mortgage works so you can make an informed decision.
Fixed-Rate Mortgage vs. Adjustable-Rate Mortgage
By far the most popular type of mortgage in the United States is a 30-year fixed-rate mortgage, which means the term of the loan is 30 years and the interest rate is fixed – or stays the same – for all 30 years. Approximately 90% of home buyers choose a fixed mortgage. While a 30-year term is the most common, a 15-year fixed-rate mortgage is a good choice for some.
A less common type of mortgage is the adjustable-rate mortgage or ARM. How does an adjustable-rate mortgage work? The term of an ARM is in two parts:
- Fixed-rate period. With an adjustable-rate mortgage, the interest rate you pay as a homeowner is fixed for a number of years at the beginning of the term of the loan. Fixed-rate periods are generally three, five, seven, or 10 years.
- Adjustment period. Then, the interest rate adjusts – usually every 12 months – after the fixed-rate period ends.
Let’s look at an example: say you have a 30-year ARM with a five-year fixed-rate period. This means your rate would not change for the first five years of the loan. After that, your rate could go up or down for the remaining 25 years of the loan.
Adjustable-rate mortgages usually start with a lower interest rate than fixed-rate mortgages, so an ARM can be an excellent choice if you’re looking for the lowest possible rate.
That low rate may change after the initial fixed-rate period, however, causing your payments to fluctuate. But payment caps limit how much your mortgage rate and monthly payment can increase. These include:
- Initial adjustment cap. This limits the amount the interest rate can go up the first time the payment adjusts.
- Subsequent adjustment cap. This limits rate increases after the first adjustment.
- Lifetime adjustment cap. This is a limit on total rate increases for the life of the loan. For example, regardless of market conditions, the rate can’t increase more than 5% over the loan term.
Adjustable-Rate Mortgage Pros and Cons
Choosing an ARM has benefits, but there’s also a downside.
- Low payments during the fixed-rate phase. Your introductory interest rate is locked in before it can change, which gives you predictable low payments.
- Flexibility. If you know you plan to sell the home or pay off the mortgage before the fixed-rate period ends, an ARM could be a good choice.
- Your payments may go down. If interest rates drop, your monthly payment during the adjustment period could also decrease.
- Your payment may go up. If interest rates rise, your payments could increase after the adjustment period starts.
- Prepayment penalty. Depending on your loan, you could be charged a fee if you sell or refinance the loan.
- ARMs can be complicated. Adjustable-rate mortgages are more complex than fixed-rate mortgages, so be sure to understand the rules and fees so you can make the best decision.
Why Choose an Adjustable-Rate Mortgage?
With a fixed-rate mortgage, the interest rate will never go up. So, why would you consider giving up that certainty in favor of an adjustable-rate mortgage? The simple answer is to pay less each month at the beginning of the term of the loan. Adjustable-rate mortgages can make sense in the following scenarios:
- You will be selling the home. An ARM may be your best choice if you plan to sell and relocate before the fixed-rate period ends. This is especially true if you’re buying a starter home.
- You’re expecting an increase in income. Your interest rate and monthly payments will start out low. You could time the adjustment period to coincide with receiving money windfall or substantial increase in income.
- You will be paying off the mortgage soon. If you intend to pay off the mortgage before the fixed-rate period ends, make sure it does not come with a prepayment penalty.
While fixed-rate mortgages are generally safer and more predictable, an adjustable-rate loan can be a good fit for homeowners who expect to move or sell in a few years. You’ll want to weigh your options carefully and choose the type of mortgage that makes the most sense for your individual situation. Contact a mortgage officer near you if you have questions about getting a mortgage.
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