Pros and Cons of Adjustable-Rate Mortgages

The vast majority of home mortgages today fall into two categories. The first and most popular type of home mortgage has a fixed interest rate. For the life of the home loan, the interest rate never changes and the payment stays the same.

The second type of home mortgage has a variable interest rate. In a true variable-rate mortgage, the interest rate can change monthly, so what the majority of borrowers choose is a hybrid, called an adjustable-rate mortgage, or ARM. An ARM combines the stability of a fixed interest rate for the first few years with possible rate changes spread out over the remaining years.

With the popular 5/1 ARM, the interest rate is fixed for the first five years (the "5"), then adjusts at one-year intervals (the "1"). In response to the housing crisis of 2008, most variable-rate mortgages today include caps to how much the interest rate can rise per year as well as over the life of the mortgage. Other adjustable-rate mortgage options include 3/1, 7/1, and 10/1.

Adjustment can occur more frequently than once a year, such as with a 5/6 ARM. "5/6" indicates that the interest rate is fixed for the first five years, then could go up or down every six months.

What determines the new interest rate?

The new interest rate will almost always derive from an index rate, such as the Prime Rate or the Fed funds rate, plus a loan margin. These indexes are driven by the market and published by a neutral party. The index an ARM is tied to will be disclosed on the mortgage estimate.

As fixed-rate mortgages become more expensive and home prices continue to rise, we are seeing variable-rate mortgages gain in popularity. Basically, they're not as scary as they once were. Modern-day caps on how high the interest rate can rise per year (a direct result of the 2008 housing crisis) reassure borrowers that their payment is less likely to increase beyond affordability.

"Adjustable-rate mortgages (ARMs) are up significantly amid rising interest rates, and homebuyers and investors are flocking to ARMs for better affordability and yields," reported CoreLogic a few months ago.

A variable interest rate might be invitingly low for a while, but what happens when it's time for the rate to adjust? Fortunately, you have several options.

Adjustable-Rate Mortgage Pros and Cons

We've all seen commercials for those mobile phone contracts that are highly affordable for a few months and then adjust to standard pricing. Those low-priced trial periods after which the price snaps to normal. Adjustable-rate mortgages are a little like that. An ARM usually offers a teaser rate lower than other home loan rates at the time, and agrees to freeze that rate for a few years, then . . . Surprise!

Adjustable-Rate Mortgage PROS

• Lower interest rate than fixed-rate home loans
• Lower payments during the initial period
• Lower payments (sometimes) if interest rates drop

Adjustable-Rate Mortgage CONS

• Higher payments if interest rates rise
• Unpredictability makes financial planning more difficult
• Payments could rise to a level the homeowner can't afford

Qualifying for an ARM is different from qualifying for a fixed-rate mortgage. Most lenders will predict how high your payment could go as the result of rising interest rates over the life of the loan, and if they still approve you, it's because they think you can handle the adjustments. If you get approved for an ARM, you could take that as an encouraging sign from the analysts who are in a position to estimate things the average borrower cannot.

Another possible drawback of an adjustable-rate mortgage is psychological. Whereas a fixed-rate home loan is "set it and forget it"—your payment is determined at the start and never changes—with an ARM you might not go more than a few months at a time without thinking of your payment. "What sucks is you are constantly concerned with the value of the home, the mortgage rates, and the clock ticking away at your increase," says a poster on Reddit.

Why Would Someone Choose an Adjustable-Rate Mortgage?

In a period of low interest rates, locking in a rate for several years with an ARM could work out well for a homebuyer who intends to sell sooner rather than later.

If rates have fallen after the initial number of years, the mortgage will adjust to the lower rate, ensuring 12 more months of comfortable payments for the homeowner.

If rates are nearly the same after the initial number of years, the adjustment will hardly be noticeable. A homeowner who expected to put the home on the market at this point could take another year to mull over the decision.

And if rates have risen after the initial years, you would have two options to deal with the hit to your household budget.

Two Options for Dealing With a Higher Interest Rate When an ARM Adjusts

First, you could compare refinancing options in the hopes of securing an interest rate close to what you are accustomed to. How's that possible if prevailing rates are higher? Well, your credit score probably improved since you took out the adjustable-rate mortgage. Five years of on-time payments could easily boost your score, and credit score is one of the key determiners of your mortgage interest rate. Also, you only need a 25-year mortgage this time around, and that could lower the interest rate (don't start over with a 30-year loan).

Second, you could remember that one of the reasons you signed on for a 5/1 adjustable-rate mortgage was because you expected to sell around the five-year mark. Your home is probably worth more today. Property values have gone up quite a bit these past five years. That’s a return on investment you could realize by selling.

Plus, the higher mortgage payment might not be so bad if you're making more money now than you made five years ago. It all depends on how high interest rates have climbed since you took out the adjustable-rate mortgage and how your expenses changed in five years. You might no longer have a car payment, for example, and you could have paid off a high-interest credit card. In short, your household budget might be able to absorb a climb of 1% or 2%.

For example, the payment on a $250,000 loan at 4% for 30 years is $1,194. Five years pass. Now, if the interest rate adjusts to 5.5%, the payment climbs to $1,535, an increase of $341. That's probably not enough to drive you to sell, especially not if you really love the house. And besides, interest rates could go down next year.

All ARMs Are Not Alike

Before you take on an adjustable-rate mortgage, the Consumer Financial Protection Bureau recommends that you learn the following.

• How high your interest rate and payments can go with each adjustment
• How frequently your interest rate will adjust
• How soon your payment could go up
• If there is a cap on how high your interest rate could go
• If there is a limit on how low your interest rate could go
• If you will still be able to afford the loan if the rate and payment go up to the maximums allowed under the loan contract

In the fine print of an ARM, you might discover that the rate adjustment is capped going down but not going up. That's a bad setup. Not being able to benefit when interest rates fall removes a primary benefit of gambling on an ARM rather than choosing a fixed-rate mortgage. On the other hand, sometimes a limit on how low your interest rate can go is a sensible trade-off for a tight cap on how high it could go.

You Could Start With an Adjustable Rate, Then Refinance to a Fixed Rate

Another strategy for managing an adjustable-rate mortgage that is about to adjust to a much higher interest rate is to refinance to a fixed rate. This way you can enjoy the lower payments of an ARM for the initial period of the loan and switch to a fixed rate for however many years remain (don't add years).

During the fifth year of a 5/1 ARM would be a good time to explore refinancing.

The Federal Housing Administration offers two 5/1 ARM options through approved lenders. The first option caps any increase at 1% annually and 5% over the life of the mortgage. The next option caps the increases at 2% annually and 6% over the life of the mortgage.

"Personally, I wouldn’t see a compelling reason to choose an ARM if I were in the market for a mortgage today," says Bay Area real estate professional Joe Parsons. "But for many people, it has been a choice that has worked well. The single most important piece of advice I can offer is to know how an ARM works before making the choice. Compare the cost to an equivalent fixed rate loan, then decide whether the difference in cost is appealing enough to you justify the future uncertainty about the rate."

You might get the benefits of a refinance without the red tape if you tell your lender that you're shopping around for better options ahead of the expected rate increase on your adjustable-rate mortgage, advises New Jersey and Pennsylvania real estate pro Allan Kolins. "You can shop around get a good understanding of what’s available, and tell your lender if they match or beat some else’s rate and conditions you’ll stay with them. There’s a lot less work for them to make changes versus processing a new person’s loan. Some banks will lower your interest rate and convert an ARM to a conventional loan at no cost or minimal cost (i.e., outside appraisal) to you while reducing your monthly mortgage fee."

Key Adjustable-Rate Mortgage Takeaways

• Interest rates on ARMs are generally lower than on fixed-rate mortgages.
• The payment on an ARM will go up or down after an initial period.
• Caps might limit how much your interest rate can rise or fall; know all the caps when considering an ARM.