Why adjustable rate mortgages are bad

And up. Which can really cost you an arm and a leg, pun intended. The rate remains unchanged for a specific amount of time—usually a year, five years, or seven years—depending on the type of ARM. And then, the honeymoon is over.

Since interest rates have been historically low lately, chances are, your lender will raise the rate to make up for rising interest rates. Because mortgage lenders have so much flexibility when it comes to how they structure your mortgage, there are countless types of ARMs out there.

Each one varies in its introductory period, interest rate, adjustment period, and other factors. Almost all adjustable rate mortgages are advertised as a series of two numbers. That would mean you have an introductory period of three years, and the bank can change the rate once a year. Basically, the first number tells you how long the introductory rate is going to be, and the second number shows how often the lender can adjust the rate. But be careful. Banks also use different terms in their advertising, and it can get confusing.

Oh, yes. It seems pretty straightforward at first. Okay, cool. Got it. But when it all boils down, this still leaves a lot of questions unanswered: How much can your lender increase your rate each year? At first glance, it might look like this advertised ARM introduces a third part. The second number says how much the lender can adjust your interest rate each year afterward. This is then the rate until the next reset, which may be the following year. ARMs are significantly more complicated than fixed-rate loans, so exploring the pros and cons requires an understanding of some basic terminology.

Here are some concepts borrowers need to know before selecting an ARM:. The biggest advantage of an ARM is that it is considerably cheaper than a fixed-rate mortgage, at least for the first three, five, or seven years. ARMs are also attractive because their low initial payments often enable the borrower to qualify for a larger loan and, in a falling-interest-rate environment, allow the borrower to enjoy lower interest rates and lower payments without the need to refinance the mortgage.

A borrower who chooses an ARM may save several hundred dollars a month for up to seven years, after which their costs are likely to rise.

The new rate will be based on market rates, not the initial below-market rate. If you're very lucky, it may be lower depending on what the market rates are like at the time of the rate reset. The ARM, however, can pose some significant downsides. With an ARM, your monthly payment may change frequently over the life of the loan. And if you take on a large loan, you could be in trouble when interest rates rise: Some ARMs are structured so that interest rates can nearly double in just a few years.

Indeed, adjustable-rate mortgages went out of favor with many financial planners after the subprime mortgage meltdown of , which ushered in an era of foreclosures and short sales. Borrowers faced sticker shock when their ARMs adjusted, and their payments skyrocketed. Fortunately, since then government regulations and legislation have been instituted to increase the oversight that transformed a housing bubble into a global financial crisis. Lenders are lending to borrowers who are likely to repay their loans.

When choosing a mortgage, you need to consider a wide range of personal factors and balance them with the economic realities of an ever-changing marketplace. To put your loan selection into the context of these factors, consider the following questions:. If you are considering an ARM, you should run the numbers to determine the worst-case scenario.

If you can still afford it if the mortgage resets to the maximum cap in the future, an ARM will save you money every month. Ideally, you should use the savings compared to a fixed-rate mortgage to make extra principal payments each month, so that the total loan is smaller when the reset occurs, further lowering costs.

If interest rates are climbing or a steady, predictable payment is important to you, a fixed-rate mortgage may be the way to go. As mentioned earlier, the fixed-rate period of an ARM varies, typically from one year to seven years, which is why an ARM might not make sense for people who plan to keep their home for more than that. A year fixed-rate mortgage, in comparison, would give you an interest rate of 4.

If you plan to move before the five-year ARM resets, you are going to save a lot of money on interest. If, on the other hand, you ultimately decide to stay in the house longer, especially if rates are higher when your loan adjusts, then the mortgage is going to cost more than the fixed-rate loan would have. However, if you expect to see an increase in your income, going with an ARM could save you from paying a lot of interest over the long haul.

The chances are high that you are going to earn more in the coming years and will be able to afford the increased payments when your loan adjusts to a higher rate. In that case, an ARM will work for you. In another scenario, if you expect to start receiving money from a trust at a certain age, you could get an ARM that resets in the same year. Taking out an adjustable-rate mortgage is very attractive to mortgage borrowers who have, or will have, the cash to pay off the loan before the new interest rate kicks in.

Take a borrower who is buying one house and selling another one at the same time. That person may be forced to purchase the new home while the old one is in contract and, as a result, will take out a one- or two-year ARM.

Once the borrower has the proceeds from the sale, they can turn around to pay off the ARM with the proceeds from the home sale. Another situation in which an ARM would make sense is if you can afford to accelerate the payments each month by enough to pay it off before it resets. Employing this strategy can be risky because life is unpredictable. While you may be able to afford to make accelerated payments now, if you get sick, lose your job, or the boiler goes, that may no longer be an option.

Regardless of the loan type you select, choosing carefully will help you avoid costly mistakes. You may get a similar rate at the time of reset, but it is a serious gamble. Consumer Financial Protection Bureau. Fannie Mae. Freddie Mac. Was this article helpful? Share your feedback. Send feedback to the editorial team. Rate this Article. Thank You for your feedback! Something went wrong. Please try again later. Best Of. Types of Mortages. Mortgage Basics. More from. Mortgage Broker Vs. Loan Officer Vs.

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