The Pros and Cons of ARMs
When interest rates rise, it’s common for some homebuyers to explore whether an adjustable rate mortgage would make sense for them.
With an ARM, as it’s called, the appeal is its lower initial interest rate compared with a traditional 30-year fixed-rate mortgage. Yet down the road, that rate can change, and sometimes not to your benefit.
While no one can determine or predict where interest rate will go from here, however the question seems to have evolved into just how high these rates will reach. Interest rates remain low from a historical perspective but have been generally rising amid a housing market that already is posing affordability challenges for buyers.
The average fixed rate on a 30-year mortgage is 5.09%, up from below 3% in November and the highest it’s been since 2018. By comparison, the average introductory rate on one popular ARM is at 4.04%. With ARMs, the initial interest rate is fixed for a set amount of time. After that, the rate could go up or down, or remain unchanged. That uncertainty makes an ARM a riskier proposition than a fixed-rate mortgage. This holds true whether you use an ARM to purchase a home or to refinance a loan on a home you already own.
For starters, consider the name of the ARM. For a so-called 5/1 ARM, for instance, the introductory rate lasts five years (the “5”) and after that the rate can change once a year (the “1″).
Some lenders also offer ARMs with the introductory rate lasting three years (a 3/1 ARM), seven years (a 7/1 ARM) and 10 years (a 10/1 ARM).
Aside from knowing when the interest rate could begin to change and how often, you need to know how much that adjustment could be and what the maximum rate charged could be.
An Adjustable Rate Mortgage generally comes with caps on the annual adjustment and over the life of the loan. However, they can vary among lenders, which makes it important to fully understand the terms of your loan.
- Initial adjustment cap. This cap says how much the interest rate can increase the first time it adjusts after the fixed-rate period expires. It’s common for this cap to be 2% — meaning that at the first rate change, the new rate can’t be more than 2 percentage points higher than the initial rate during the fixed-rate period.
- Subsequent adjustment cap. This clause shows how much the interest rate can increase in the adjustment periods that follow. This number is commonly 2%, meaning that the new rate can’t be more than 2 percentage points higher than the previous rate.
- Lifetime adjustment cap. This term means how much the interest rate can increase in total over the life of the loan. This cap is often 5%, meaning that the rate can never be 5 percentage points higher than the initial rate. However, some lenders may have a higher cap.
An ARM may make sense for buyers who anticipate moving before the initial rate period expires. However, because life happens and it’s impossible to predict future economic conditions, it’s wise to consider the possibility that you won’t be able to move or sell.
O’Brien, Sarah. “Considering an Adjustable Rate Mortgage? Be Sure You Fully Understand the Risks.” CNBC, CNBC, 6 June 2022, www.cnbc.com/2022/06/06/considering-an-adjustable-rate-mortgage-be-sure-to-understand-risks.html.