Considering An Adjustable-Rate Mortgage? Here’s When They May Be the Best Fit

With interest rates up slightly in recent months, many potential homebuyers are shying away from fixed-rate mortgages and looking toward adjustable-rate ones (also called ARMs) instead.

ARMs typically come with lower interest rates — at least at the start of the loan — and can save buyers lots of cash in the beginning.

In fact, according to a senior economist at First American, choosing an ARM can actually increase home buying power by about $30,000 for the average consumer. For many, that can mean an extra bedroom, a newer property or even a better location.

When Are the Best Times to Use an ARM?

So are ARMs right for every buyer on a strapped budget? Even in a rising rate situation, they’re not.

ARMs can be a great product, but they’re not without risk. And if used improperly, they could end up costing buyers thousands more in interest in the long run.

Are you considering an adjustable-rate mortgage to save cash on your home purchase? Here are the most common scenarios in which an ARM may be a good idea:

• You’re not sticking around for long – If you know you won’t be in the home for the long haul, an ARM may very well be the best choice for you. Have plans to change jobs or locales in five years? Know you’ll need a bigger house once you have kids? Then simply choose an ARM term that fits your goals. A 5/1 ARM gives you a fixed rate for five years before the rate adjusts. You can also choose 3, 7, and even 10-year ARMs, but the shorter the term, the lower your rate will usually be.
• You’re buying an expensive home – Rates on adjustable- and fixed-rate loans diverge the most on jumbo-sized loans — those above $453,100 in most areas. That means on those bigger home purchases, you’ll likely pay a lot more for a fixed-rate loan, especially at the outset. If you’re planning to move in a few years or you’re willing to refinance not too far down the line, it may be in your best interest to use an ARM for your initial purchase.
• You’ll have the means to pay off your loan before the adjustable term is up – Expecting a windfall of money in a few years? Know you’ll be selling off investments  Then you might be able to pay off your mortgage before the fixed-rate period is up. This would let you enjoy the reduced rates, without all the risk that ARMs typically come with.

First-time home buyers may particularly benefit from ARM loans, as they often come with less cash to the table — meaning a lower rate can significantly expand their buying power. Still, whether you’re a first-time buyer or fall into one of the above categories, ARMs aren’t without risk — and understanding those risks is crucial to leveraging these types of loans properly (and without losing money in the process!)

The Possible Risks of Using ARMs

If you fall into one of the above categories or you just want to consider leveraging those lower ARM rates, then make sure you know what you’re getting into.

After the initial fixed-rate period, your interest rate on an ARM can fluctuate greatly — sometimes as much as 1 or 2 full percentage points. This can significantly increase your monthly mortgage payment and reduce your household cash flow.

Make sure you’re properly prepared for your rate increase, or that you apply to refinance your loan well before the fixed period is up (though there’s no guarantee refinance rates will be favorable at that time). You can use your existing mortgage lender for your refinance, or you can go to a different lender if you choose. Rates and closing costs will vary from lender to lender, so it pays to shop around and get quotes if a refi is the route you plan to take.

Finally, compare the spread between rates (how much adjustable and fixed rates diverge), and be extra sure the savings are worth the added risk. If they are, and you know you can financially benefit from choosing an adjustable mortgage, then move forward with your application.

A few quick pro tips as you do, though: Make sure there are protections in place on your loan. There should be both a rate cap and an increase cap, which ensure your interest can’t skyrocket on a whim. You should also have a clear understanding of both when your rate can increase, as well as how much that increase will impact your monthly payment.

Is Adjustable-Rate Right for You?

According to data from Ellie Mae, ARM loans are up from last year — almost a full percentage point since 2017. But are they right for your unique situation? They could be. Get in touch with an Embrace loan officer today for personalized guidance. We’ll help you make the best decision for your household.