Adjustable Rate Mortgages: Pros and Cons

ARM mortgages are a major source of confusion, but do not merit the negative connotation that follows the term. The financial crisis of 2008 comes to mind when many consumers hear the term ARM. You may not have known that Arms made up over 49 percent of all mortgages back in 2005.

But don’t confuse them with sub-prime mortgages. The latter as you remember were a big part of the financial crises. The buyers who qualified for subprime had low credit scores and/or couldn’t provide income verification. But the vast majority of subprime mortgages were ARM’s.

ARM (adjustable-rate mortgage) mortgages certainly have a firm place in the marketplace today.

We are going to go over what exactly an adjustable rate mortgage is, how it works, and offer some real life examples. Finally, we will discuss who might actually want to enter into one of these mortgages.

An ARM Defined

To explain what an ARM is, it might be easier to compare it to a conventional mortgage. We all know that a conventional or fixed-rate mortgage has an interest rate and mortgage payments that never changes throughout the life of the loan. Whether you have a 15 or 30 year mortgage, the consumer makes a payment that never changes  regardless of the changes in the interest rate environment.
Adjustable-rate mortgages have an interest rate that can change based upon market conditions. It is usually tied to an index.

We will answer one question right now that many people have.

Are adjustable rate mortgages bad? NO, they are not bad when borrowers understand what they are getting into and the terms of the loans.

  • The only reason anyone would agree to an ARM is for the lower payment. All adjustable rate mortgages start out with a “teaser period”. This period acts like a fixed rate mortgage. The interest rate and payment will not change. This period is usually 3 or 5 years. But it could be less or even more. It all depends on the type you decide to choose.

Also, they are attractive to borrowers who don’t plan to spend too long in their residence. If a buyer knows that they tend to move a lot, or that a job or other life event in the future will force them to relocate, then this might be the perfect arrangement. 

Adjustments and Caps

Before we get into real world examples, there are a few other details a consumer should be aware of. Each ARM will have an adjustment period and cap. Many of these mortgages will adjust once a year after the “teaser rate” has expired. However, some rates can change every 6 months.

Caps will limit the amount the rate can increase over the life of the loan. For example, if you entered into a 15 year ARM, and the interest rate cap was 5%, and by year 9 the rate had already increased by that latter amount, the rate could NO LONGER go any higher.

The adjustment can be very confusing. It’s possible that although interest rates don’t go up, your payment still might. This is why so many buyers found themselves in hot water during the 2008 financial crisis. A good ARM calculator can show you live examples of how a mortgage payment can changed based upon the rate. 

mortgage calculator

Here is an ARM Mortgage example:

Suppose the maximum amount rates can go up in an adjustment period of your mortgage is 1%. The mortgage index your rate is tied to goes up 2%. By law, the maximum amount your lender can increase your rate will be 1%. But that is just for that period. Even if rates then don’t go up or down the following period, you can bet that lenders will raise your rate another 1%. They will make up for the 1% they were unable to increase from the previous period.

Many consumers aren’t aware that the above example can occur. Also, many homeowners think they can get out of their house before the “teaser period” is over. But if they cannot sell their house or the market value declines, they may find themselves in a difficult situation.

Real Life Examples in the Wild 

Here are some of the more popular ARM mortgage that might make sense today.

3/1 or 5/1 ARM:

The first number you see is the “teaser period”. In essence your mortgage rate and payment will be fixed for the first 3 or 5 years. Then the second number represents how often the rate will adjust until you sell the house or pay off the mortgage. In both of these cases, the mortgage rates will adjust every year after that teaser period expires.

There is also a 10/1 which might be the closest you will get to a fixed rate mortgage. It allows you 10 years of a fixed payment. Considering, this is a long time and gives you ample time to consider your options. 

3/3 ARM:

Again, the first number represents how long the initial fixed period will last. Now in this example, the rate can only adjust once every 3 years

So if you chose the 3/3, your rate would adjust in years 4, 7, 10, and so on until you paid off or sold your home. 

Upside: If rates were to spike during the middle of year 4, your payment wouldn’t increase until potentially year 7. 

Downside. The opposite also holds true. If rates were to decrease during the first few months of year 4, your mortgage wouldn’t be able to decline until there rate were to reset for year 7. 

2 Step Mortgage:

This type is very easy to understand. It has only one adjustment period. So in essence, you pay one rate for one portion of the mortgage and another rate for the next.

Of course all ARM’s will have different rates. Usually the shorter the initial teaser period, the lower the interest rate will be.

Other items of Concern

Remember that banks are not in the business of losing money. Be aware that many of these mortgage instruments may carry prepayment penalties. If you think that you can sell or pay off your home early, then you may discover there are heavy fees to do so. You will want to ask the lender about any penalties that exist on your loan.

Even if you go with a 3/1 ARM and decide to sell the house after just 2 years, you may find yourself responsible for thousands of additional dollars.

Who Shouldn’t Apply for an ARM

There is a certain type of buyer who shouldn’t apply for an ARM mortgage. 

  • Anybody on a fixed income that wouldn’t be able to afford the mortgage payment that would come with a rate increase.  Or someone with a limited amount of savings. 
  • This could cause great hardship and potentially a foreclosure. 
  • Buyers who cannot tolerate much risk. If interest rates were to spike this certainly could cause someone great anxiety. 

Final Thoughts

Most people will suggest to go with the conventional mortgage because your payment will remain a consistent price; this is perfect for people on a fixed income.

  • ARM’s can be a great option for buyers who tend to move around a lot or don’t stay in the same home very long. The rate of interest is very low in the beginning of the loan.
  • It’s not for someone who knows they are going to be in the home for a very long time. 
  • Look over here for some great information about what you need to get pre-approved for a mortgage. Many intelligent buyers have profited off ARM’s in the last decade or so thanks to an unusually low interest rate period.

Buyer beware!

Resources we used:

Frequently Asked Questions
Currently have a 5 1 adjustable rate mortgage should i refinance?

You should only refinance if you payment will go down substantially. Rates are very low now. In a 5/1 mortgage, the rate will reset after 5 years. But given the current interest rate climate, the rate shouldn't increase much. In fact, it may go down.
Now if you feel rates are going higher very soon, then you may want to refinance, especially if this will be your primary residence for the next 30 years or so.

Should we refinance our adjustable rate mortgage?

Right now we are in a period of historically low interest rates with no signs of it increasing anytime soon. Rates will no doubt go higher in the future. You might want to take advantage of the lower rates today!

Remember if you refinance, then generally you have to start over by making payments on your home. Supposed you are in the 5th year of a 30 year mortgage. if you refinance now and do another 30 year, that means you have to start making payments all over again.


Pros and cons of adjustable rate mortgage?

There is one Main pro of an adjustable rate mortgage. It offers and initial lower interest rate than a conventional rate mortgage. The main con is that your rate may reset causing your mortgage payment to go up.