If you’re considering your mortgage options when making your home-buying plans, one option to consider is an adjustable-rate mortgage, or ARM, which can offer both advantages and drawbacks for potential homebuyers.
“An adjustable–rate mortgage has an interest rate that is not fixed, but is subject to change at regular intervals during the life of the loan,” says Greg McBride, chief financial analyst with Bankrate.
When weighing your options, where’s what experts say to consider:
What are the advantages?
According to Holden Lewis, home and mortgage expert at NerdWallet, an ARM’s introductory interest rate is usually lower than the rate on a comparable fixed-rate mortgage. The lower interest rate means the monthly payments are lower for a given loan amount, which makes homes more affordable. It also means that buyers can use an ARM to stretch, and buy a house that they couldn’t afford with a fixed-rate loan.
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What are the risks of an ARM?
Lewis tells FOX Business that the biggest risk of an ARM is that the interest rate could rise past the point where the monthly payments are easily affordable.
“ARMs start out with an introductory interest rate, and most ARMs can climb five points higher than that introductory rate. So an ARM could start out with an introductory rate of 6%, with the possibility of rising five percentage points to 11%. It’s hard to judge how likely it is that an ARM would reach its highest possible interest rate,” he says.
Is an ARM the right choice for you?
An ARM might be a suitable choice, says Lewis, when you’re buying a house that you won’t own for long.
“For example, if you think you’ll move within five or six years, you might choose to get a 5-year ARM, with an introductory rate that lasts five years,” Lewis explains.
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Another scenario that may be a fit for an ARM is for buyers who expect their incomes to rise substantially.
“A classic example is someone in a medical residency program whose income will go way up in a few years after they complete their residency program,” Lewis says. Professional athletes and people in show business might anticipate big increases in income, too, he adds.
And finally, someone who expects a financial windfall might opt for an ARM with the aim of paying off the mortgage when the money drop happens, Lewis says.
How does the market affect the rates for adjustable rates? Does inflation affect it?
ARMs are linked to an index called the Secured Overnight Financing Rate, or SOFR.
The “SOFR index responds to myriad market forces, including the inflation rate and the federal funds rate,” explains Lewis. The 30-day average SOFR, which ARM rates are indexed to, has gone up about 4.77 percentage points since the beginning of 2022, and the federal funds rate has gone up 4.75 percentage points at the same time, Lewis says.
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Does it matter the length of the loan?
Lewis says a 5-year ARM’s introductory interest rate lasts five years, and a 7-year ARM and 10-year ARM have introductory rates that last seven and 10 years, respectively.
“The more years, the higher the rate,” he explains. “Borrowers take this into account. For example, if someone wants to avoid rate adjustments and they plan to live in the house for seven years, they would prefer a 7-year ARM over a 5-year ARM.”
Is an ARM right for you?
As noted, there are pros and cons of choosing an ARM. Your lender should be able to answer your questions and concerns and lead you through the lending process. But, knowing the pros and cons is important to making an informed decision.
“The main risk with an ARM loan is the uncertainty of where rates will be at time of adjustment,” explains Tony Clintock, national retail sales manager at U.S. Bank Home Lending who is based in New Jersey. “The rate could adjust annually after the fixed rate portion but does have limits on annual adjustments and lifetime adjustments, which somewhat limits exposure.”
He says most lenders offer a 2% annual cap and a 5% lifetime cap with the initial rate being the starting point.
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But, a lower introductory rate can offer advantages for the borrower.
“With an adjustable-rate mortgage, the borrower shoulders some of the risk of rising interest rates, and less risk is borne by the lender or investor that owns the loan,” says McBride. “The initial rate tends to be lower than it would be with a fixed-rate mortgage where the lender or investor bears all the rate risk and the borrower bears none.”
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