Mortgage shoppers looking for some flexibility on interest owed on a home loan may want to kick the tires on adjustable-rate mortgages.
Adjustable-rate mortgages, known more informally as ARMs or “variable rate” mortgages, offer something that fixed-rate mortgages cannot – interest rates that change over time.
“An adjustable-rate mortgage is just what it sounds like,” said Elysia Stobbe, a home financing specialist and author of “How To Get Approved for the Best Mortgage Without Sticking a Fork in Your Eye.” “Your interest rate adjusts periodically during the course of the loan.”
During the life of the loan, the interest rate will change based on benchmark index rates. “ARMs usually have changing interest rates after a set period of time; the change in interest rate happens at a predetermined time and then adjusts periodically, again at predetermined times,” Stobbe said.
Those timetables usually reset fairly early, especially with 30-year mortgage loans.
“Adjustable-rate mortgages are subject to 'periodic rate adjustments' which are scheduled every three years, five years, or seven years, for example, based on the specific loan program,” said Anna DeSimone, a housing finance consultant and author of the book “Housing Finance 2020.”
ARMs and fixed-rate mortgages: What’s the difference?
ARMs vary from traditional fixed-rate mortgages as they have scheduled changes in the rate of interest.
“Any mortgage program that is subject to a change in rate or loan payment during the term of the loan is generally classified as a non-fixed loan,” said DeSimone. “Because the initial payment period begins with a lower rate of interest, you will see the term 'starter rate' with adjustable-rate mortgages.”
That’s not the case with fixed-rate mortgages.
A fixed-rate mortgage means that the terms of the loan, such as interest rate and term, remain the same.
“Basically, a fixed-rate mortgage will never change unless you refinance the home,” said Caleb Liu, owner of HouseSimplySold.com, a home purchase investment firm based in Southern California. “Every month you pay the same amount, even if the market interest rates go up or down.”
Pros and cons of ARMs
Adjustable-rate mortgages have upsides and downsides, financial experts say.
Advantages of an adjustable-rate mortgage
They’re good for short-term homeowners. ARMs are a practical choice for homeowners who plan to refinance their loan or sell the home within five to 10 years, Desimone said. “This lessens the chance for the loan to reach the maximum rate. For these homebuyers, a five-or-seven-year ARM can be a good choice.”
They make it easier to qualify for a mortgage. For people looking to buy a starter home, an ARM loan can make a difference in loan qualification. “Plus, for homeowners seeking a cash-out refinance in order to complete renovations, an ARM loan can help bring in needed cash that will boost the property value,” Desimone added.
Disadvantages of an adjustable-rate mortgage
Rates will go higher. Get ready for higher interest rates with ARMs. “Mortgage rates and payments can increase after the initial fixed term,” said Alan Rosenbaum, CEO of GuardHill Financial Corp. in New York City.
The “surprise” factor. ARM users may be surprised by the loan’s first rate adjustment. “Most homebuyers obtain the mortgage and promptly forget about it,” Liu said. “Rates may creep up over several years, and the homeowner is surprised by both the timing and the amount of the rate hike.”
How you could benefit from an adjustable-rate mortgage
Adjustable-rate mortgages offer value to homebuyers on multiple fronts. First, they allow buyers to get more home equity for their money, by saving on interest rates upfront. They also allow borrowers to utilize falling interest rates without needing to refinance first.
Owners looking to sell a home within the low interest rate period, before they rise, can benefit, as well. This is especially applicable for homeowners who aren't planning on remaining in the home for longer than 10 years.