3 Reasons an ARM Mortgage Is a Bad Idea

By Jordan Wathen Markets Fool.com

Adjustable-rate mortgages aren't for everyone, and can be a very bad idea for some people. An ARM offers a short-term fixed rate now in exchange for potentially higher rates later. A 5/1 ARM, for example, would have a fixed rate for 5 years, and reset once per year thereafter.

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The advantage of an ARM is an apparently lower initial interest rate and smaller monthly payment, but there are a few scenarios where an ARM can be less than ideal.

1. You're already stretched

The mortgage industry employs a fantastic rule of thumb for mortgage affordability. Underwriters prefer that a borrower's recurring monthly payments add up to less than 36% of a borrower's gross income.

Here are some monthly expenses that lenders take into consideration:

  • Mortgage payment (principal and interest)
  • Homeowners insurance
  • Property taxes
  • Student loans, car loans, credit cards, etc. (non-mortgage debt)
  • Child support

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Lenders add up the monthly payments on each of the above. If the total is more than 36% of your gross income, you wouldn't qualify for the loan under conventional underwriting criteria.

Run the math for yourself. If your ratio is higher than 36%, you're stretched and can ill-afford to take on the risk of a higher monthly payment in the event interest rates rise. A 30-year fixed-rate mortgage would likely be a much better choice.

If interest rates skyrocket, your mortgage rate will follow, and so will your payment. At 3.5%, a payment on a $200,000 mortgage is just $898 for 30 years. At 6%, the mortgage payment would jump to $1,199!

How many people can afford an unexpected 33% increase in their mortgage payments?

Image source: Getty Images.

2. You plan on staying in your home

Adjustable-rate mortgages are excellent for people who expect to move frequently. Each time you move, you'll have to take out a new mortgage at a new interest rate, so the benefits of locking in a rate for 30 years are largely irrelevant.

But if you anticipate that you'll live in your new home forever, it's worth considering a fixed-rate mortgage as a way to have a knowable monthly payment for as long as you live in the same place.

No one can predict the future of interest rates with any certainty, but it's possible that people who refinanced or bought a home in the summers of 2012 and 2016 received the lowest mortgage rates they'll ever see in their lifetimes. If rates go to 6%, those who signed a 30-year mortgage at 3.5% will look like geniuses with their relatively tiny monthly payments.

3. You can afford higher payments

As I write this, there is virtually zero difference between the rate on a 5/1 ARM and a 15-year fixed mortgage. If you can afford the higher monthly payment, locking in the same rate for 15 years rather than 5 years may be advantageous.

Mortgage type

Principal amount

Rate

Monthly payment

Time to pay in full

5/1 ARM

$200,000

3.45%

$892.52 (Until reset for year 6)

30 years

15-year fixed

$200,000

3.48%

$1,427.80

15 years

Remember that most adjustable-rate mortgages are based on a 30-year term. Thus, only after 30 years does the loan balance fall to zero. Because a 15-year mortgage is paid off so much faster, the lender doesn't have as much risk, so it's often possible to get a 15-year mortgage at the same rate as a 5/1 ARM.

Of course, there's the obvious downside. All else equal, the only way to pay off a mortgage twice as fast is to make larger monthly payments. At current interest rates, a 15-year fixed mortgage payment will be about 60% larger than a 5/1 ARM.

It's not for everyone, but before choosing an ARM for a lower interest rate, you might want to see how the rate compares to a 15-year mortgage.

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