When Does an Adjustable-Rate Mortgage Make Sense?
When you’re shopping for a mortgage, the rates you’ll see quoted for adjustable-rate mortgages look awfully tempting. In nearly every case, they’ll be significantly lower than a standard 30-year fixed-rate mortgage.
That’s because these rates only apply for a short period of time — typically going up significantly after a period with that lower rate.
However, adjustable-rate mortgages have their uses. Below, we argue for the two instances when it makes sense to borrow an ARM for a home purchase: if you’re planning to pay off your loan quickly, or if you plan to sell your home before the fixed-rate period ends.
What makes an ARM different?
An adjustable-rate mortgage is a home loan that has an interest rate that changes multiple times over the term of the loan, which is usually 30 years. That’s different from fixed-rate mortgages, where the interest rate stays the same for the entire period.
Most ARMs begin with a fixed interest rate for a period of five or seven years. Once the fixed-rate period ends, the interest rate becomes variable and adjusts periodically.
You can easily see how long the initial fixed rate period will last by looking at how the loan is marketed. If you borrow a 5/1 ARM, for example, your interest rate would be fixed for five years and then adjust annually thereafter for the remaining 25 years of the mortgage term.
The new, adjustable rate is partly determined by an index, which is a broad measure of interest rates. Some ARMs come with interest rate caps, meaning there’s a limit to how high the rate can adjust.
Because an ARM typically has a lower rate than a fixed-rate mortgage — for the first few years, at least — it can help you buy a home and start paying down your mortgage at a lower monthly cost than you could manage with a fixed-rate mortgage.
Let’s take a look at the cost differences between a 30-year fixed-rate mortgage and a 5/1 ARM during the first five years.
|30-year fixed||5/1 ARM|
(Principal and interest)
|Principal paid after 5 years||$4,327.55||$4,499.45|
|Interest paid after 5 years||$6,882.77||$6,291.02|
As shown above, the 5/1 ARM is less costly over the first five years of the mortgage term. Due to having a lower interest rate, you could save nearly $35 on your monthly payment and nearly $600 in interest. You’d also pay down just over $170 of your outstanding principal balance.
What to expect after the first adjustment
Your lender may have a limit in place for how much your interest rate can increase when it adjusts for the first time after the fixed-rate period ends. The initial adjustment cap could be 2% or even 5%, according to the Consumer Financial Protection Bureau.
Based on the example above, a 2% interest rate bump would push the 5/1 ARM’s principal and interest payment from $899.21 to $1,136.83 — a monthly difference of $237.62. This drastic jump in the monthly payment amount could push the mortgage into an unaffordable territory.
Cases when an ARM makes more sense
Adjustable-rate mortgages don’t suit every homebuyer, but there are certain instances when they make more sense:
- When you plan to pay off your mortgage very quickly.
- When you’re planning to sell your home in a few years.
Getting rid of your mortgage at a rapid pace
An ARM’s lower initial interest rate can work in your favor if you have the means to pay off your mortgage in a much shorter time frame than what a 30-year term calls for.
That’s exactly what Meg Bartelt, CFP and founder of Flow Financial Planning, and her husband did when they bought their home. Although the couple’s cash was largely tied up in investments, they had enough to buy their home outright. Still, selling the investments for the home purchase would’ve pushed them into a much higher tax bracket and increased their tax burden.
“By taking an ARM, we can spread the sale of those investments out over five years, minimizing the income increase in each year. That keeps our tax bracket lower,” Bartelt said. “We avoided increasing our marginal tax rate by double digits in the year of the purchase of our home.”
Another reason the ARM also worked in her family’s favor was the fact that they could continue to pay the mortgage past that initial five years if they chose to do so. “The interest rate won’t be as favorable as if we’d initially locked in a fixed rate,” she admitted, “but that option still exists, and having options is power.”
Selling your home before the rate adjusts
Another way ARMs can provide benefits to homeowners? If you won’t live in the home for long. Buying the home and then selling it before the initial fixed-rate period expires could provide you with a way to access the lowest possible rate without having to weather the eventual rise in your mortgage payment. When the interest rate adjusts, it’s more likely than not that it will significantly increase.
“ARMs are typically best for those who are fairly certain they won’t be in the house for a long period of time,” said Cary Cates, CFP and founder of Cates Financial Planning. “An example would be a person who has to move every two to four years for their job.”
His suggestion is to view an adjustable-rate mortgage as a way to pay “tax-deductible rent” — if you already know you don’t want to stay in the house for more than a few years.
“This is an aggressive strategy,” Cates explained, “but as long as the house appreciates enough in value to cover the initial costs of buying, then you could walk away only paying tax-deductible interest, which I am comparing to rent in this situation.”
You’re obviously not actually paying rent, but you can mentally frame your mortgage payment that way, Cates added. However, the risk is owing the difference between what your home sold for and your outstanding mortgage balance, if your home’s value hasn’t appreciated enough to cover what you spent to buy it.
Pros and cons of an ARM
|ARM benefits||ARM drawbacks|
|Interest rates typically start out significantly lower than fixed-rate mortgagesLower initial principal and interest paymentsYou can more quickly pay down your principal during the fixed-rate yearsWill typically include a cap on how high your interest rate can go when it adjusts||The interest rate isn’t predictable after the fixed-rate period endsInfluenced by market conditions even after they’re first borrowedYour principal and interest payments can increase dramatically, causing your mortgage to be unaffordableThe only way to get rid of an ARM (outside of paying it off) is to refinance or sell your home|
“The main advantage of an ARM is the low, initial interest rate,” Bartelt said. “But the primary risk is that the interest rate can rise to an unknown amount after the initial fixed period of just a few years expires.”
Homebuyers can enjoy extremely low interest rates for one, three, five, seven or 10 years, for example, depending on the term of their adjustable-rate mortgage. But borrowers have no control over the interest rate after that period.
When the index that the ARM is tied to rises, so does your interest rate. The rate could rise to levels that make your monthly mortgage payment unaffordable.
The variable nature of the interest rate makes it difficult to plan ahead, as the principal and interest portion of mortgage payment will no longer be stable.
“Imagine at the end of year five, rates start going up and your mortgage payment is suddenly much higher than it used to be,” said Mark Struthers, CFP, CFA and founder of Sona Financial.
“What if your partner loses their job and you need both incomes to pay the mortgage?” Struthers asked. In this situation, you could be stuck if you don’t have the credit score to refinance and get away from the higher rate, or the cash flow to handle the extra cost. “Once you get in this spiral, it is tough to get out,” he said. “The spiral just gets tighter.”
It’s easy to assume that you’ll be able to refinance into a fixed-rate mortgage before your first rate adjustment, but remember that just as you had to qualify for your original mortgage, you’ll again need to meet the qualifications to replace that loan with a brand-new one.
Read our explainer for a thorough rundown of how to refinance your mortgage.
Questions to ask before borrowing an ARM
Before applying for an adjustable-rate mortgage, be sure to reach out to multiple lenders and ask questions like:
- How long is the initial fixed-rate period? How does that compare with another mortgage option, and is it worth taking on a riskier mortgage to get the initial fixed rate?
- How often will the ARM adjust after the initial fixed-rate period?
- Is there a limit to how low the interest rate can drop?
- How high can the interest rate go? How does that affect the monthly mortgage payment?
- If the mortgage hits the maximum interest rate, would I still be able to comfortably afford the monthly payment, based on my debt-to-income ratio?
The bottom line
Borrowing an adjustable-rate mortgage may seem like a feasible idea, especially when you consider how much you can save during the early years of your mortgage. But it’s critical to consider whether the benefits outweigh the risks.
If you’re concerned about affordability, be sure you’ve developed a plan to refinance your mortgage or sell your home before the interest rate begins adjusting. Still, depending on your specific situation, your finances and your plans for the first few years following your home purchase, you could make an ARM work for you.
I am David, economist, originally from Britain, and studied in Germany and Canada. I am now living in the United States. I have a house in Ontario, but I actually never go. I wrote some books about sovereign debt, and mortgage loans. I am currently retired and dedicate most of my time to fishing. There were many topics in personal finances that have currently changed and other that I have never published before. So now in Business Finance, I found the opportunity to do so. Please let me know in the comments section which are your thoughts. Thank you and have a happy reading.