Adjustable rate mortgages (ARMs) can benefit some borrowers, but also come with substantial risks.
Below are the risks most commonly encountered with adjustable rate mortgages.
Rising monthly payments and payment shock
It is risky to focus only on your ability to make I-O or minimum payments, because you will eventually have to pay all of the interest and some of the principal each month. When that happens, the payment could increase a lot, leading to payment shock. In the worksheet example, the monthly minimum payment on the option-ARM payment rises from $630 in the first year to $1,308 in year 6, assuming the interest rate stays at 6.4%. The monthly payment could go up to $2,419 if interest rates reach the overall interest rate cap.
If you have a payment-option ARM and make only minimum payments that do not include all of the interest due, the unpaid interest is added to the principal on your mortgage, and you will owe more than you originally borrowed. And if your loan balance grows to the contract limit, your monthly payments would go up. For example, if your $180,000 loan grew to $225,000 (125% of 180,000), your payments would be recalculated.
Refinancing your mortgage
You may be able to avoid payment shock and higher monthly payments by refinancing your mortgage. But no one knows what interest rates will be in 3, 5, or 10 years. And if your loan balance is greater than the value of your home, you may not be able to refinance.
Some mortgages, including I-O mortgages and payment-option ARMs, have prepayment penalties. So if you refinance your loan during the prepayment penalty period, you could owe additional fees or a penalty. In the Mortgage Shopping Worksheet example, the penalty is 3% in the first year, 2% in the second year, and 1% in the third year. In this case, you could owe $3,600 if you refinance in year 2. Most mortgages let you make extra, additional principal payments with your monthly payment. This is not considered "prepayment," and there usually is no penalty for these extra amounts.
Falling housing prices
If housing prices fall, your home may not be worth as much as you owe on the mortgage. Even if home prices stay the same, if you have negative amortization, you may owe more on your mortgage than you could get from selling your home. Also, you may find it difficult to refinance. And if you decide to sell, you may owe the lender more than the amount you receive from the buyer.
[Source: Federal Deposit Insurance Corporation]
Meeting with a lawyer can help you understand your options and how to best protect your rights. Visit our attorney directory to find a lawyer near you who can help.
Why take an adjustable-rate mortgage (ARM)? Why not just take a fixed rate and not worry about what rates might do in the future?
That’s a fair question, and a good one. Adjustable rate mortgages can be a good choice for borrowers who anticipate financing a property for a relatively short period of time, say three to five years. ARMs can offer lower, “teaser” rates that are usually lower than fixed mortgage rates. And when caps are applied, an ARM may be the better overall choice.Check your eligibility for an ARM mortgage. Start here (Dec 6th, 2022)
What is an adjustable-rate mortgage (ARM)?
Adjustable-rate mortgages offer an introductory rate for a set number of years. After the introductory period ends, the home loan’s rate will adjust according to overall mortgage rates.
ARM loans typically offer introductory rates that are lower than the rates available for fixed-rate mortgages, which translates to lower monthly payments — during the initial period.
These initial “fixed” periods can range from 3, 5, 7 or even 10 years. The initial interest rate then adjusts, usually once per year. These loans (also called “hybrid ARM” mortgages) can make sense depending on your plans over the first 3 to 10 years of the loan term.Check today's mortgage rates here (Dec 6th, 2022)
An ARM might be a good idea when…
You will be receiving a windfall
If you plan to receive a large amount of money in the next 5 years or so, an ARM might make sense. Say that you have a piece of real estate with a lot of equity that you plan to sell. Or, you will receive an inheritance. Maybe you will sell your business in 5 years.
In any of these circumstances, you could take a very low initial rate, then pay off the mortgage loan toward the end of the fixed period, before the rate changes.
You plan to sell the home early
If you plan to sell the home in the next 5 to 7 years, an ARM might be a good choice. Perhaps you are a first-time buyer looking for a smaller property, but plan to move into a bigger home as your family grows. Or your job will move you out of the area in the next few years.
In these cases, it might make sense to cash in on a lower interest rate for a few years. Just be careful that your plans are fairly certain. If they’re not, you may want a fixed-rate loan or an ARM with a very low rate along with low rate caps.
For more about how ARMs work, see our ARM primer or contact a trusted mortgage lender.
You want a tax deduction or will soon retire
You might have the cash to buy a home outright, but want a short-term loan for the mortgage interest tax deduction. Although this website does not give tax advice, it’s a fact that the mortgage interest deduction can have a big effect on the amount of taxes you pay. Check with your tax advisor.
If you make a lot of money now but will retire in 3 to 10 years, an ARM might make sense. You may be able to use the tax deduction to reduce your current adjusted gross income (AGI) thereby reducing your tax bill.
When you retire and your income decreases, you could pay off the loan amount if you no longer need the tax deduction.
Rate caps determine how much your ARM can change
An ARM has another important series of numbers that set limits on how much your loan rate can change. This series of numbers shows your rate caps.
For example, if you have an ARM with a 2/2/5 cap, your rate cannot change by more than:
So, with a 2/2/5 cap on a 5/1 ARM with an introductory interest rate of 3%, your loan’s rate:
Could never surpass 8% during the life of the loan
These lifetime caps on ARMs protect borrowers from out-of-control rate increases, but even a 5% rate increase would mean much higher monthly payments.
You’d want to refinance out of your ARM before its intro rate expires, especially during a high-rate environment.
So is an ARM for everyone?
For most home buyers, a fixed-rate mortgage will be the loan of choice since it still offers incredible interest rates and stability for the future.
With an ARM, rate adjustments can mean an eventual higher interest rate and higher monthly mortgage payment. If rates rise then you could end up with an expensive new rate (and higher loan payments) once the introductory rate period ends.
Still, there are many situations in which an ARM might make sense. Especially when interests are high, ARM rates are likely to be lower than fixed interest rates and might help aspiring buyers to become homeowners.
A mortgage professional can help you determine which type of mortgage is the best choice for you, based on your personal finances and current market conditions.Check your eligibility for an ARM mortgage. Start here (Dec 6th, 2022)
Potential homebuyers exit an open house in Redondo Beach, California.
As interest rates tick upward, it may be tempting for homebuyers to explore adjustable rate mortgages.
The appeal of an ARM, as it's called, can be the lower initial interest rate compared with a traditional 30-year fixed-rate mortgage. However, that rate can change down the road — and not necessarily in your favor.
"There is a lot of variability in the specific terms as to how much the rates can go up and how quickly," said certified financial planner David Mendels, director of planning at Creative Financial Concepts in New York. "No one can predict what rates will do, but one thing is clear — there is a whole lot more room on the upside than there is on the downside."
Interest rates remain low from a historical perspective but have been rising amid a housing market that already is posing affordability challenges for buyers. The median list price of a home in the U.S. is $405,000, up 14% from a year ago, according to Realtor.com.
The average fixed rate on a 30-year mortgage is 4.67%, up from below 3% in November and the highest it's been since late 2018, according to the Federal Reserve Bank of St. Louis. By comparison, the average introductory rate on one popular ARM is at 3.5%.
With these mortgages, 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.
If you're exploring an ARM, there are a few things to know.
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.
"Don't just think in terms of a 1% or 2% increase," Mendels said. "Could you cope with a maximum increase?"
Mortgage lenders employ an index and add an agreed-upon percentage point (called the margin) to arrive at the total rate you pay. Commonly used benchmarks include the one-year Libor, which stands for the London Interbank Offered Rate, or the weekly yield on the one-year Treasury bill.
So if the index used by the lender is at 1% and your margin is 2.75%, you'll pay 3.75%. After five years with a 5/1 ARM, if the index is at, say, 2%, your total would be 4.75%. But if the index is at, say, 5% after five years? Whether your interest rate could jump that much depends on the terms of your contract.
An ARM 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.
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.
"I'd also be concerned if you do an ARM with a low down payment," said Stephen Rinaldi, president and founder of Rinaldi Group, a mortgage broker. "If the market corrects for whatever reason and home values drop, you could be underwater on the house and unable to get out of the ARM."
Rinaldi said ARMs tend to make the most sense for more expensive homes because the amount saved with the initial rate can be thousands of dollars a year.
"The difference between 3.5% and 5% can be $400 a month," Rinaldi said. "On a 7/1 ARM that could mean saving $5,000 a year or $35,000 altogether, so I can see the logic in that."
For a mortgage under about $200,000, the savings are less and may not be worth choosing an ARM over a fixed rate, he said.
"I don't think it's worth the risk to save $100 or so a month," Rinaldi said.