Does an Adjustable Rate Mortgage Make Sense Right Now?

No doubt if you’re looking to purchase a home, you’re aware that interest rates just went up in March. Fixed-rate mortgages function exactly as their name implies. When you lock in (or "fix") an interest rate, it stays the same for the length of the loan, whether it's 15 or 30 years. Fixed-rate mortgages are ideal for purchasers who want to stay in their houses for a long period because they provide predictability.

 

It's amazing how much a few weeks can change things. According to Bankrate's nationwide survey of lenders, rates have risen quickly since the beginning of the year, rising to near 4.75 percent for 30-year mortgages and just below 3.9 percent for 15-year mortgages. Unfortunately for prospective buyers and refinancers, this more expensive rate environment is likely to become the new normal, and all signs point to higher mortgage rates in the coming weeks and months.

 

That said, one mortgage option that may be just right for you and your family is an Adjustable Rate Mortgage (ARM). ARMs have a fixed rate for the first five, seven, or ten years, but then they adjust. The interest rate is recalculated every year (or potentially more frequently) after the initial period finishes throughout the balance of the loan term. The interest rate may go up or decrease with each modification, depending on market rates. Although ARMs have lower beginning interest rates than fixed-rate mortgages, they are far less predictable in the long run.

 

An Adjustable Rate Mortgage is usually described as "5/1" or "10/1." The first number indicates how long the original interest rate is fixed (referred to as the “initial cap”), while the second indicates how often it can change after that (called the “periodic cap”).

 

A 5/1 ARM, for example, would have a fixed interest rate for the first five years, then adjust each year for the balance of the loan's term. It's worth noting that there may be yearly and lifetime limits on how high an ARM's interest rate can go. Once the limited-term expires, you may see a significant increase.

 

What Makes an ARM a Great Option?

By design, ARMs keep your mortgage payments low while you’re locked into your rate for the period of the original interest rate (initial cap). That said, this type of mortgage is a great option if you plan on staying in your home for 7 to 10 years. And because interest rates usually fluctuate every 7 to 8 years, you can always refinance should the interest rate become unmanageable. This is great news since the federal reserve is expected to raise interest rates several more times this year.

 

When Should You Consider an Adjustable Rate Mortgage?

If you expect your earnings to rise. Because ARMs often have lower beginning interest rates than fixed-rate mortgages, you can minimize your monthly payments during the first few years of homeownership when money is tight.

 

If you're just going to be in the house for a short time. If you plan to sell your house before the first fixed time ends, an ARM may be a good option.

If you intend to put your monthly savings into investments. During the initial fixed-rate period, you might invest the monthly savings from the ARM's lower rate. But think about whether that amount is worth the higher interest rate you might incur in the future.

 

BOTTOM LINE

If you’re looking to purchase a home and are afraid of rising interest rates, an Adjustable Rate Mortgage may be a great option for you. Your mortgage payments will be lower than a conventional loan and the rate will be locked in. And locking in your rate now in a year when the federal reserve is expected to raise interest rates several more times is an awesome feature!