In determining what type of mortgage may be best for you, it is important to know that, with an adjustable-rate mortgage (ARM), you will receive a lower interest rate upfront, with a variable rate after that. This may enable you to afford more house initially, but could be problematic if the rate rises beyond a level you are comfortable paying. With a 5/1 ARM, your rate is fixed for five years. Afterward, if the market interest rate goes up, so does your payment. If you cannot afford the uncertainty of a rate that may fluctuate upward, you may want to go for a fixed-rate mortgage.
- an ARM if you will be in your property for a limited time
- an ARM to get the benefit of a lower payment
- an ARM for a low start rate if you can invest your funds
- an ARM and get a lower rate if you have an early payoff plan
- an ARM in a falling interest-rate environment
- do an ARM if you are going to be in the property long term
- do an ARM if you can only qualify at the low start rate
- do an ARM if you don't understand all parameters
- do an ARM if you need to roll in closing costs into the rate
- do an ARM with plans to refinance
As a rule, there is usually 0.5%-1.0% difference in rate for an ARM, which can be quite substantial in a monthly mortgage payment. The first 5 years of any loan, you are paying about 95% interest vs. principal, so it makes sense to utilize the lower rate and payment. Conversely, if you are concerned about paying down the principle of the loan sooner or being able to pay a potentially higher payment once the initial period of the loan passes, go with a fixed-rate loan, as the short-term savings may not be worth it to you.
An adjustable rate mortgage is great to lower your payment for a temporarily fix period of time, normally 3, 5, or 7 years. A 5/1 ARM refers to your interest rate being fixed at one level for five years. But if you need to know what your payment will be beyond the initial period of an ARM or if you cannot risk not being able to afford a potentially higher payment later, then an ARM may not be right for you. A fixed-rate loan may be a better choice for you.
If your start rate is 2.25% and you know you can make double that or more by investing it and getting a higher yield in the market, it makes sense to do an ARM. Still, if you will not actively seek to invest the difference (between what you are paying and what you could earn on the funds left in play) or you are not sure you can make up or “best” that difference, you may not want to pursue an ARM.
So, for instance, if you have a 5/1 ARM, meaning your rate will change – likely going up – after the initial five-year term, you don’t have to worry about that potential jump in the rate if you plan to pay off the loan prior to the five-year mark. The source of your anticipated payoff could be from any number of sources, such as the sale of another property or asset, bonus income, inheritance or such another influx of money necessary to cover the payoff of the loan. If you are not sure when or how you can pay off the loan and are not comfortable with the adjustment that can come after the first five-years of the loan, choose a fixed-rate mortgage.
With interest rates being low, it is highly unlikely that they would fall enough after the initial period of your ARM to make it worthwhile, that is, if it’s not already worthwhile for you for other reasons. A lower interest rate also allows you to have a lower mortgage payment without having to refinance further down the road. Rates are pretty low right now, so your rate is not likely to go down after the initial term of your loan. So, if you are starting with a relatively low rate anyway, even on a fixed-term loan, you may want to go that route, rather than an ARM.
Most ARMs come with a 5% life cap, so even if your start rate is low (i.e. 2.25%), you could end up with a 7% rate over a 30-year term. If you are going to be in the property long term and you can start out with a good rate on a fixed-term mortgage, that may be the best route for you.
An ARM will eventually go up and you need to be prepared for the higher payment in case your plans change and you need to move for whatever reason. So, if you can only budget for the monthly payment required during the initial term of the loan, and you are unsure how you will make a higher payment if and when the rate increases, an ARM is not an appropriate choice for you. Choose a fixed-rate loan.
For instance, what will the initial rate be on your ARM? What is the period for which the rate will remain unchanged? What are the interest rate caps, meaning how much can the interest rate or monthly payment change? How often can the rate change? Are there any initial discounts which could create savings for you during the first year of the ARM? Will there be negative amortization, which means your balance is increasing because the monthly payments you are making initially do not cover all of the interest due on the mortgage? Is there an option for a conversion, meaning you can convert your ARM to a fixed-rate mortgage at designated times? Will you face prepayment penalties if the ARM is paid off early?
It may go without saying, but you need a mortgage representative who can and will help you understand the terms of a loan, especially in the case of an ARM, since there are variable during the life of the loan, which is not a consideration with a fixed-rate loan – the terms of which will remain the same during the life of the loan.
The yields on an ARM are usually not high enough to cover closing costs. In other words, any savings achieved by doing an ARM are not enough to cover the additional costs – the closing costs – you would roll into the rate. So, if you need to finance your closing costs, choose a fixed-rate loan rather than an ARM.
If you are self-employed, or become newly self-employed, you have to average your income for 2 years with 2 years of tax returns. With deductions that self-employment allows, sometimes your income is not enough to qualify, especially if it is declining income. If you have plans to refinance in the future and the stability of your income and assets are questionable, or if it could affect qualifying you for a fixed loan when it is time to refinance, an ARM might not be the right route for you. If you have uneven or potentially changing income or if you anticipate needing to refinance, choose a fixed-rate mortgage.
A fixed-rate mortgage generally costs a bit more per month during the first few years of your mortgage, but you know what your payment will be for the term of your loan – for instance, if you are locked in for 30 years. An adjustable-rate mortgage (ARM) might be an option, depending on your circumstances and strategy. For instance, if you will be in the property for a limited time, if you have an early payoff plan in mind, or if during the initial, lower-payment period of your loan you could better invest additional/surplus funds elsewhere.