Adjustable rate mortgages or ARMs got a bad rap thanks to the 2008 housing meltdown, but these types of loans do make sense for some borrowers.
ARMs can be appealing to homeowners because they typically offer a lower interest rate for the first couple of years compared to fixed-rate mortgages, but the rate changes periodically, (usually in relation to an index), causing payments to fluctuate.
Many experts point to adjustable-rate mortgages made to unqualified homeowners as a main catalyst of the Great Recession. Many borrowers ran into trouble a few years back because they couldn’t afford the monthly mortgage payment once the loan adjusted, leading to massive foreclosures, and causing major banks to write down millions-and in some cases, billions-of dollars of bad loans.
Variable-rate mortgages are still available today, but with record-low interest rates, the difference between the rate on a 30-year fixed rate mortgage and an ARM is not much different, making the product not as advantageous.
“It’s not nearly as popular as it was a couple years ago. You see them become popular when interest rates rise,” says Bob Walters, chief economist at mortgage lender Quicken Loans. “Even now though, there are always situations when ARMs make perfect sense.”
According to mortgage experts, individuals who don’t plan to stay in their home for a long period of time can benefit from an ARM because they can take advantage of the lower rate and not have to worry about affording the mortgage payment once the loan adjusts.
“First-time home buyers historically will be in their home for three to five years or five to seven years,” says Gene Lugat, senior vice president, eastern division, for mortgage lender PrimeLending. For people expecting to stay in a home for more than five to seven years, an ARM does not make financial sense, he says.
Other candidates for an ARM are people who expect their incomes to grow steadily over the course of the years. “With any young professionals coming into the work force, their propensity for their income to increase is fairly significant,” says Lugat, noting the growth of income should be able to match a higher monthly payment when the mortgage adjusts.
A person that’s income is fixed or potentially declining wouldn’t be a good candidate for an ARM. People in or nearing retirement, or a self-employed homeowner that can’t guarantee a steady increase in income, are not good ARM candidates.
Homeowners planning to stay in a house for an extended period of time can still be a candidate for an ARM if they have money in the bank to handle the increased payment, says Walters. “People who have more means tend to take ARMs. People with good jobs but zero money in the bank are candidates for a fixed-rate loan.’’
In the past, borrowers would enter into an adjustable-rate mortgage with an eye toward refinancing before the mortgage rate resets. But as history has proven, that strategy is fraught with risk. There is a good chance the home’s value drops, making the owner unable to refinance because there’s not enough equity in the home. What’s more, the requirements to refinance have become a lot stricter, limiting individual’s ability to move into a fixed loan to avoid the rise in monthly payments. “You shouldn’t go into an ARM if you need to refinance in the future,” warns Lugat.