Whether you’re purchasing a home or refinancing your current mortgage, your lender may have given you the option of taking out an adjustable rate mortgage (ARM). ARMs can be great options, but it’s important to understand how they work before making your decision.
ARMs have interest rates that change over the life of the mortgage. After an initial fixed-rate interest period—usually of three, five, seven, or 10 years—the interest rate can fluctuate. These fluctuations happen at certain intervals, often annually, and are based on an index specified in the mortgage closing documents. ARMs can have caps on how high your interest rate can go each year, as well as over the life of the loan.
For example, a 5/1 ARM has an initial fixed-rate interest period of five years, and it then adjusts annually after that five-year period ends. When the loan resets, the homeowner has the option of selling, refinancing, or paying the higher monthly amounts.
If you’re on the fence about whether to lock in a rate for 30 years or opt for an ARM, here are some things to consider.
How soon you’ll pay off the loan. If you’re taking out an ARM, you need to think about whether you’ll want to pay off the loan before the interest rate adjusts. Fortunately, this doesn’t mean draining your savings to pay off the loan. By refinancing, you can pay off the ARM and take out a new loan. (Of course, you’ll be paying whatever the going interest rate is at that time on that new loan.)
Keep in mind that if you have an interest-only ARM, you may have a problem when you go to refinance because you won’t have enough equity in your home. Lenders like to see 20 percent equity or more on a refinancing, though you may be able to refinance with less equity by taking out private mortgage insurance (PMI).
The length of time you’ll be in the home. Perhaps you already know that in the next five years, you will have to move for your job. Maybe you plan to expand your family soon and know you’ll need to move to a larger home. Taking out an ARM with an initial period of low payments may be a good home financing strategy if you are confident you can sell the home before the fixed-rate period ends. If you’re planning on staying longer than the initial fixed-rate period, you might want to opt for a different longer-term fixed-rate loan, especially when interest rates are low.
Your future income prospects. It’s hard to forecast your future when it comes to your career and future income. If you’re just starting your career, however, it’s highly possible that your future income will be higher than your current income. For example, according to the National Association of Realtors 2014 Home Buyer and Seller Generational Trends report, the median household income of homebuyers under 33 years old is $73,600. For homebuyers between the ages of 34 and 48, the median household income is $98,200.
While you might expect your income to grow, consider other factors as well. If you plan to have children, perhaps you or your significant other will take several years off to stay home and raise them, lowering your income for that period. Or, perhaps you’re working in an unpredictable industry and could face layoffs in the coming years.
Deciding to take out an ARM to stretch your finances and buy a home you can’t afford is probably not a good idea. When you’re searching for a mortgage, don’t let anyone—friends, family, even your mortgage broker—talk you into an ARM. Do your own research and weigh the pros and cons objectively. In the final analysis, you should go ahead only if you are confident that, should your ARM reset, you can weather the higher payments without risking your home or your quality of life.
Steve Cook is executive vice president of Reecon Advisors and covers government and industry news for the Reecon Advisory Report. He is a member of the National Press Club, the Public Relations Society of America, and the National Association of Real Estate Editors, where he served as second vice president. Twice he has been named one of the 100 most influential people in real estate. In addition to serving as managing editor of the Report, Cook provides public relations consulting services to real estate companies, financial services companies, and trade associations, including some of the leading companies in online residential real estate.