The adjustable rate mortgage craze was part of what led to the housing and financial crisis that we are still recovering from. Adjustable rate mortgages (ARMs) usually have lower interest rates than traditional mortgages when they are first disbursed. This leads to lower payments, which makes it easier for people to take on large mortgages that potentially can become unaffordable when the ARM adjusts.
The housing crisis came when a number of people tried to sell their houses before the rate reset to an amount that was impossible to pay. Too many houses on the market led to not enough being sold, which led to a number of people being forced into foreclosure. Needless to say, ARMs got kind of a bad reputation for the role they played in our nation’s financial crisis! But in some circumstances, they are still a good choice for someone seeking to finance (or refinance) a house.
What is an adjustable rate mortgage?
An ARM is just what it sounds like – a mortgage whose rate is set for a certain amount of time, and then adjusts when that initial period is over. The rate can adjust once or repeatedly. Some ARM terms that are traditional in the US call for one rate for either three or five years, with an annual reset after that. The rate is usually tied to some index, such as the prime lending rate or the US Treasury bond rate, with the lender using a formula to add additional percentage points to those rates. Most (though not all) ARMS contain two caps: one to limit the amount that the rate can increase in any one year, and one to limit the total amount that it can increase over the life of the loan. Of course if the borrower gets really lucky, the rate might actually decrease! This happened to many people in recent years when interest rates hit nearly rock-bottom.
When to consider an ARM
A fixed-rate mortgage locks you into a rate for the duration of the loan (unless rates drop enough/you build up enough equity to refinance), while an ARM has the possibility of either increasing or decreasing. There is a certain amount of gambling involved in taking out an ARM, but it could also just turn out to be smart hedging if rates do in fact go down years after you find your dream house. An ARM makes sense in certain home-buying situations. Some of these are:
- You know for sure that your pay will increase before the rate resets, and you can therefore afford slightly higher payments in a few years
- You know that your expenses will decrease before the rate resets, potentially due to paying off other debt - again, allowing you to afford higher payments in a few years
- You will be selling your house before the rate resets – this could be true for a military family or other homebuyers in a certain location for a set period of time. In this case, an ARM would make sense because you could take advantage of lower rates now without having to risk higher rates later. Of course you should always make sure that you can afford the increase if and when it does come to pass.
- You are buying your home with a large down payment, therefore beginning with high equity and a better chance of selling or being able to refinance at a later date.
- You suspect that interest rates are high compared to where they will be in the future, and you therefore have a chance to lower your rate when it adjusts. This is of course somewhat speculative – once again, make sure that you can afford the increase if that is what ends up happening.
What to look for
If you are thinking about purchasing a house and taking out an ARM, make sure you look for the following features to help you find a mortgage that is perfect for you:
- An initial interest rate lower than the prevailing rate for a traditional mortgage
- No penalty for making early payments, or payments greater than the minimum
- An adjustable rate with caps on both annual and total increases
- An option to convert to a traditional fixed-rate mortgage at some point in the future, if desired/necessary
- An interest rate that is low enough and a payment high enough that you are paying down principal in the initial period – you do not want a loan that has you paying only interest until the rate resets!
Shopping for an adjustable rate mortgage
Be sure to shop around and compare terms to find the best rates on an ARM. To get started, check out the following interest rate comparisons: