Adjustable-Rate Mortgage Pros and Cons: Is It Right For You?

With interest rates soaring and even homebuyers with excellent credit faced with interest rates over 7%, an adjustable-rate mortgage (ARM) offers the hope of future reprieve. 

An adjustable-rate mortgage adapts based on market conditions, which means your interest rate could drop if market conditions are more favorable in the future. Likewise, many ARMs offer lower fixed rates for a period of three to 10 years, making them an attractive option for homebuyers who plan to move. Read on for adjustable-rate mortgage pros and cons to decide whether this loan opportunity suits you. 

What Is an Adjustable-Rate Mortgage?

An ARM is a home loan where the interest rate and monthly payments may change over time, typically after an initial fixed-rate period of three, five or seven years. Once the fixed-rate period ends, the interest rate adjusts annually or every six months. Adjustable-rate mortgages have a stated maximum upward adjustment per year and over the loan term called cap and floor rules so you’ll know the maximum you could have to pay. 

ARM interest rates are tied to a reference fund, such as the yield on one-year Treasury bills, the 11th District Cost of Funds Index (COFI) or the Secured Overnight Financing Rate (SOFR). Your interest rate is typically stated as one of these index rates plus a margin, such as the SOFR plus 2%. 

When the annual or biannual adjustment occurs, the interest on your loan is recalculated based on your principal balance and the new interest rate. The monthly mortgage payments will rise or fall proportionately. 

Pros of Adjustable-Rate Mortgages (ARM)

Adjustable-rate mortgages offer significant advantages, especially in times of high interest or when you plan to resell the house within a few years. Here is an overview of ARM pros. 

Lower Initial Interest Rate

ARMs often offer lower starting interest rates compared to fixed-rate mortgages, making them more affordable in the short term. The lower fixed interest rates last three to 10 years, making them an attractive option for homebuyers who plan to move, refinance or purchase a new home before the fixed-rate period ends.

Potential for Lower Payments

If interest rates decrease, the monthly payments on an ARM may also decrease, providing potential savings. This is especially valuable when interest rates have reached a 20-year high. With a longer fixed-rate period, you have the potential for lower interest rates when the rate adjusts.

Flexibility

ARMs offer flexibility regarding mortgage repayment options, allowing borrowers to choose from different fixed-rate periods and adjustment intervals. Adjustment intervals are typically every six months or one year, while fixed-rate periods could be as short as 12 months or as long as 10 years. The terms you choose can affect interest rates, allowing you to compare terms to find the best option.  

Lower Closing Costs

Adjustable-rate mortgages typically have lower closing costs than fixed-rate mortgages, making them a more affordable option upfront. With an ARM, you can potentially save more on closing and secure a lower interest rate during the introductory period.

Shorter Adjustment Periods

Some ARMs offer shorter adjustment periods, meaning the interest rates can be adjusted more frequently based on market conditions. While an annual adjustment is the most common, many offer adjustments every six months.  

Ability to Qualify for a Larger Loan

The lower initial payments of an ARM can help you potentially to qualify for a larger loan, allowing you to purchase a more desirable property. The lower payment can make qualifying for your dream home or a stretch purchase easier.

Potential for Lower Interest Over Time

If interest rates decrease and you take advantage of the lower payments by paying more toward the principal, you could save significantly on interest over the life of the loan. Making even one additional mortgage payment per year could help you save thousands in interest. 

Investment Opportunity

When you have an ARM, you can use the lower payments during fixed-rate periods to invest in other ventures, potentially increasing your financial portfolio or saving more for retirement. 

Income Increases

ARMs allow for increased mortgage payments if the borrower’s income rises, providing an opportunity to make larger payments and pay off the mortgage faster. This could save thousands in the long run and allow you to build equity in the home and pay off the loan faster.

Refinancing Option

If interest rates rise significantly or if your financial situation improves, you always have the option to refinance the ARM into a fixed-rate mortgage. This flexibility means you can secure lower interest rates now during the ARM’s fixed-rate period and still get a better rate if you improve mortgage qualifying requirements or if average fixed-rate mortgage rates drop.

Cons of Adjustable-Rate Mortgages (ARMs)

While ARMs can offer a more stable entry into a first home or a solution if you plan to move within a few years, there are some significant disadvantages to them because of uncertainty over potential interest rate increases. Here’s what you will want to consider. 

Uncertainty

The variable nature of ARMs introduces uncertainty as interest rates can fluctuate over the life of the loan, making it difficult for borrowers to predict future payments. With each adjustment period, you’ll need to adjust your budget accordingly, potentially paying significantly more if interest rates rise. 

Potential Rate Increases

The interest rates on ARMs can rise, causing monthly payments to increase, potentially straining your financial stability. If the initial mortgage rate was a stretch, a price increase can increase the risk of defaulting on the loan or force you to cut back in other areas. 

Payment Shock 

Significant rate increases can lead to payment shock, where borrowers may struggle to afford higher monthly payments, potentially leading to financial stress or default. In that case, you could be left looking for a side hustle or struggling to find alternative income streams to make up the difference. 

Limited Budget Planning

With changing interest rates, it becomes challenging for borrowers to plan and budget their finances effectively, especially in the long term. Will you have an extra $100 next year, or will it have to go to mortgage interest? With an ARM, you won’t be able to predict future monthly payments beyond the current adjustment.

Longer Repayment Period

Sometimes, you could request a longer repayment period to cover the loan. If interest rates rise, borrowers might need a longer repayment period to repay the increased loan amount, extending the mortgage term and potentially increasing the overall interest paid.

Difficulty Selling the Property

If interest rates rise significantly, potential buyers may be deterred by the higher interest rates associated with the ARM, making it harder to sell the property. If, on the other hand, you have an assumable mortgage, that can be a point of attraction for prospective homebuyers. 

Negative Equity Risk

In declining housing markets or if property values decrease, borrowers with ARMs might find themselves owing more on the mortgage than the property’s market value, leading to negative equity. This can be frustrating when even if you were to sell the home, you wouldn’t be able to pay off the mortgage in full. 

Prepayment Penalties

Some ARMs may impose financial penalties if the mortgage is paid off early or refinanced before a specific period. This can be a significant disadvantage, especially if you want to pay off the loan faster and save on interest. Check the loan terms carefully to understand any prepayment penalties. 

Higher Long-Term Costs

If interest rates consistently rise, borrowers with ARMs might pay more in interest over the life of the loan compared to a fixed-rate mortgage. This is especially true if the mortgage has prepayment penalties and high-interest rates. 

Complex Mortgage Terms

Adjustable-rate mortgages can have complex terms, including adjustment caps, index rates and margin rates, making it essential for borrowers to thoroughly understand the details before committing to an ARM. If the terms seem unfamiliar, speaking with a real estate attorney to understand them and your obligations in the mortgage can be helpful. Learn more about the common ARM or variable rate mortgage terms here. 

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Should You Get an ARM?

Whether an adjustable-rate mortgage makes sense for your situation depends on current interest rates, the best available rates and your financial situation. If you plan to move or refinance in a few years, an ARM can offer a fixed lower interest rate. Carefully weigh adjustable-rate mortgage pros and cons for your situation, and consider speaking to mortgage brokers to help secure the best available options. You can see how to qualify for a Federal Housing Administration (FHA)- loan or figure out how much your home is worth, and then find the best mortgage rates here.

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